•  Corporation   Finance  '^ 


A  Study  of  the  Principles  and  Methods  of  the 
Management  of  the  Finances  of  Corporations 
IN  the  United  States;  with  Special  Reference 
to  the  Valuation  of  Corporation  Securities 


BY 

THOMAS  L.  GREENE 

VICE-PRESIDENT,  THE  AUDIT  COMPANY  OP  NEW  YORK 
FORMERLY  AUDITOR,  MANHATTAN  TRUST  COMPANY 


THIRD  EDITION 


G.  P.  PUTNAM'S  SONS 

NEW  YORK  LONDON 

27  WEST  TWENTY-THIRD  STREET  24  BEDFORD  STREET,  STRAND 


MAY  2y  laii 

Copyright,  1897 

BY 

G.  P.  PUTNAM'S  SONS 
Entered  at  Stationers'  Hall,  London 


%bc  Knicfcerbocfter  pxc»5,  'new  fiorfc 


PREFACE. 

BEFORE  there  can  be  any  intelligent  discussion  of 
the  problems  which  arise  in  the  management  of 
corporations,  it  is  necessary  that  there  shall  be  a  wider 
knowledge  of  the  objects  sought  in  corporation  finan- 
ciering, and  of  the  practical  reasons  which  have  led  to 
the  policy  pursued  in  the  United  States,  together  with 
its  results. 

Some  suggestions  have  been  made  which  may,  I 
trust,  prove  of  service  to  the  large  class  of  business 
men  and  lawyers  who  are  not  infrequently  called  upon 
to  deal  with  the  incorporation  or  with  the  administra- 
tion of  an  industrial  undertaking  ;  in  the  description  of 
the  methods  of  practical  finance  the  attempt  has  like- 
wise been  made  to  supplement  the  text-books  already 
in  the  hands  of  educators  and  students. 

Experience  has  developed  and  brought  into  promi- 
nence business  rules  and  facts  which  will  be  useful  to  an 
investor  in  estipiating  the  value  of  the  bonds  or  shares 
of  corporations  in  which  he  may  be  interested,  and  it 
has  been  the  aim  to  present  these  rules  and  practices  in 
such  a  manner  as,  while  technical  in  its  precision,  shall 
also  be  available  for  the  purposes  of  the  general  reader. 

T.  L.  G. 

New  York  City,  March,  1897. 


219354 


CONTENTS. 


CHAPTER  FAOB 

I. — Bonds  and  Stocks        .       .        .       •  i 

II. — Forms  of  Corporat]^  Entkrpris^       .  i6 

III. — RaiIvWAy  Bonds     .        .        .        .        .33 

IV. — Subsidiary  Companies  and  thkir  SiS- 

CURITIES 63 

v.— Corporation  Accounting    ...  80 

VI. — Thk  Examination  of  Raii^way  Re- 
ports           102 

VII. — PUB1.1C  P01.1CY  TOWARDS  Corporation 

Profits 131 

VIII. — Corporation    Rejorganizations    and 

Rkckivkrships 146 


c 


Digitized  by  the  Internet  Archive 

in  2007  with  funding  from 

IVIicrosoft  Corporation 


http://www.archive.org/details/corporationfinanOOgreerich 


CORPORATION  FINANCE 


CHAPTER  I 

BONDS  AND  STOCKS 

THE  business  man  or  firm  must  borrow  money. 
With  the  few  exceptions,  where  firms  have  com- 
mand of  practically  unlimited  sums  of  their  own, 
business  success  is  possible  only  through  the  aid  of  the 
money-lender.  Let  us  suppose  for  illustration  that  a 
firm  employs  a  capital  of  $1,000,000  in  its  business,  one 
half  of  which  it  borrows  from  the  banks  on  its  commer- 
cial paper  at  six  per  cent,  interest.  We  will  suppose 
also  that  the  firm  *'  turns  its  capital  over ''  six  times  a 
year,  which  is  only  another  way  of  saying  that  its  vol- 
ume of  annual  sales  is  six  times  the  capital.  Assuming 
that  our  firm  is  enabled  to  earn  two  per  cent,  net  upon 
its  sales,  the  resulting  profits,  $120,000,  amount  to 
twelve  per  cent,  upon  the  capital  employed.  As  under 
our  assumption  the  firm  is  paying  six  per  cent,  on  the 
amount  borrowed,  or  $30,000  yearly,  it  follows  that  the 
actual  earnings  upon  the  firm's  own  capital  are  $90,000, 
or  eighteen  per  cent.,  a  handsome  return  made  possible 
only  through  the  borrowing  of  money  which  can  be 
used  to  extend  the  volume  of  trade  and  to  earn  some- 


2  Corporation  Finance 

thing  for  the  firm  over  and  above  the  percentum  of 
interest  paid.  The  actual  profits  earned  under  this 
system  vary  in  different  trades,  though  usually  the  vol- 
ume of  business  is  in  inverse  proportion  to  the  percent- 
age of  profit  on  the  annual  sales.  Whatever  sum  we 
select  or  whatever  earnings  we  assume,  the  principle 
underlying  the  illustration  is  the  same.  Of  course  a 
part  of  the  capital  of  such  firm  or  corporation  in  busi- 
ness must  be  invested  in  credits  granted  to  customers 
and  in  some  form  of  merchandise  in  stock. 

The  practical  working  out  of  this  fact  that  borrowing 
money  is  now  essential  to  business  success,  is  beneficial 
to  the  customer  of  the  firm,  to  the  consumer,  and  to  the 
people  at  large.  Competition  is  even  more  severe  be- 
tween trading  firms  than  in  the  cases  of  large  manufac- 
turing corporations  ;  profits  tend  everywhere  to  a  mini- 
mum, so  that  in  the  end  the  percentage  of  earnings  on 
sales  declines  toward  the  level  of  existence..  Slowly, 
therefore,  the  possibilities  of  profit,  under  this  system 
of  doubling  or  trebling  the  volume  of  business  through 
the  borrowing  of  capital,  are,  through  the  pressure  of 
competition,  taken  from  the  firm  and  given  to  the  pub- 
lic in  the  shape  of  lower  prices  or  superior  service. 
This  is  the  universal  law  of  trade.  If  we  suppose, 
under  our  former  illustration,  that  in  time  the  volume 
of  sales  reaches  eight  times  the  capital  employed  and 
that  the  percentage  of  profit  declines  from  two  per  cent, 
to  one  per  cent.,  making  a  return  of  $80,000  annually, 
from  which  as  before  interest  on  borrowed  capital, 
amounting  to  $30,000,  is  to  be  deducted,  we  see  that 
our  supposed  firm  has  toiled  steadily  to  increase  its 
trade,  has  taken  large  commercial  risks  in  the  way  of 
bad  debts,  declines  in  the  prices  of  commodities,  etc., 
and  has,  after  all,  made  but  ten  per  cent,  upon  its  own 


Bonds  and  Stocks  3 

capital  invested  and  hazarded  in  its  business  ;  a  return 
too  small  to  compensate  for  the  labor  and  the  danger 
of  loss.  Clearly,  however,  the  addition  of  borrowed 
capital  and  the  increased  volume  of  trade  thereby 
secured  give  advantages  of  profit,  in  which  both  firm 
and  customer  are  entitled  to  share. 

Concurrently  with  the  growth  of  firms  and  corpora- 
tions which  do  a  large  business  under  these  conditions, 
there  has  come  a  large  increase  in  the  amount  of  money 
waiting  to  be  loaned,  and  a  large  advance  in  the  meth- 
ods by  which  the  surplus  capital  of  the  world  is  col- 
lected for  loaning.  Banks,  insurance  companies,  trust 
companies,  and  savings  banks,  in  short,  firms  and  cor- 
porations, both  large  and  small,  formed  for  every  con- 
ceivable financial  purpose  and  of  every  conceivable 
kind,  now  stand  ready  to  lend  to  the  deserving  bor- 
rower. The  more  depressed  the  times,  the  more  easily 
and  cheaply  can  the  safe  borrower  secure  needed 
money.  But  the  greater  part  of  these  increasing  sums 
of  money  is  for  loan  only  upon  some  sort  of  security. 
The  lenders  who  are  willing  to  take  some  risk  are  few; 
those  who  wish  to  be  certain  of  the  return  of  their 
money  are  many.  To  secure  this  safety,  the  owners 
of  this  surplus  capital  are  willing  to  lend  it  at  a  low 
rate  of  interest.  The  unwillingness  of  the  average 
investor,  individual  or  institutional,  to  put  his  money 
at  any  business  hazard,  is  one  of  the  main  causes  for 
the  continued  fall  in  the  average  rate  of  interest. 
Capital  competes  with  capital  for  safe  investment. 

The  demand  for  security  in  loans  gives  the  business 
firm  or  corporation  its  opportunity.  If  perfectly  sound 
in  condition  and  management,  it  can  borrow  its  outside 
capital  at  a  low  rate,  and  so  increase  its  own  profits. 
The  machinery  for  gathering  money  and  loaning  it  has 


4  Corporation  Finance 

been  so  perfected,  and  tlie  knowledge  of  the  conditions 
of  safety  in  business  has  become  so  extended,  that  the 
proportion  of  borrowings  to  a  firm's  entire  capital  has 
been  much  increased.  Formerly  it  was  with  hesitancy 
that  a  bank  would  lend  a  firm  one  quarter  of  its 
required  capital ;  now,  there  is  a  temptation  for  a 
writer  to  say  that  a  quarter  of  the  firm's  own  money, 
with  three  quarters  of  borrowings,  would  be  nearer  the 
usual  proportion.  To  borrow  one  half  of  one's  neces- 
sary capital,  in  money  or  goods,  is  common.  The 
comparative  ease  of  obtaining  credit,  the  fall  in  the 
average  rate  of  profit  made  possible  by  this  increase  in 
capital,  and  the  resulting  heavy  increase  in  the  output 
and  in  the  volume  of  trading  throughout  the  world, 
made  necessary  in  order  to  earn  a  fair  return  under  the 
diminishing  ratio  of  profit,  are  the  forces  under  which 
we  are  witnessing  prosperity  and  depression  in  almost 
regular  cycles.  To  take  advantage  of  these  trade 
forces,  and  at  the  same  time  to  check  the  excesses  due 
to  them,  constitute  the  great  industrial  problem  of  our 
time. 

These  conditions  of  safe  lending  and  mercantile 
borrowing  have  drawn  a  sharp  line  of  distinction  in 
industrial  finance.  The  lenders  of  money  to  firms  or 
corporations  are  creditors,  the  stockholders  are  part- 
ners in  the  enterprise.  As  creditors  are  willing  to 
furnish  capital  up  to  the  line  of  safety,  it  has  become  a 
common  saying  that  the  bonds  of  a  corporation  ought 
to  cover  the  minimum  value  of  the  property  or  fran- 
chise, leaving  the  fluctuating  or  uncertain  part  of  the 
enterprise  to  be  represented  by  the  shares.  This  is  a 
good  rule,  but  one  which  differs  in  its  application  to 
different  cases.  lyoans  upon  real  estate  in  cities  can  be 
made  with  safety  up  to  a  larger  percentage  of  the 


Bonds  and  Stocks  5 

appraised  value  than  in  towns  or  upon  farms.  So  too 
with  corporations  or  with  firms  of  long  standing,  whose 
style  of  management  is  well  known,  the  stability  of 
whose  trade  or  trafi&c  has  been  tested  by  experience, 
and  where  the  limits  of  the  expected  fluctuations  in 
volume  of  commerce  can  be  reasonably  predicted  ; 
such  companies  or  firms  can  borrow  capital  up  to  a 
high  percentage  of  their  supposed  worth.  The  practi- 
cal test  of  this  limit  of  borrowing  is  found  by  a  con- 
sensus of  opinion  in  answer  to  this  question  :  To  what 
amount  can  commercial  paper  or  bonds  be  floated  at 
par  and  at  about  the  ruling  rate  of  interest  for  such 
borrowings  ?  Even  if  the  firm  or  company  be  in  ex- 
ceptionally good  credit  and  able  to  borrow  up  to  a  large 
percentage  of  the  real  capitalization  (including  in  this 
term  the  guaranties  and  other  fixed  charges  not 
covered  by  bonds)  yet  the  managers  should  for  their 
own  future  safety  conservatively  limit  their  borrowings 
to  the  minimum  value  of  their  property  as  the  same 
might  be  estimated  in  a  time  of  possible  adversity. 
It  is  not  good  financiering  to  sell  evidences  of  in- 
debtedness at  a  heavy  discount,  even  though  the 
stated  rate  of  interest  be  below  the  usual  percentage. 
It  is  better,  if  possible,  to  arrange  the  rate  of  interest 
so  that  the  bonds  or  notes  will  fetch  par.  It  occa- 
sionally happens  that  for  sentimental  reasons,  or  per- 
haps to  difierentiate  a  later  issue  from  former  ones,  a 
company  will  knowingly  offend  against  this  rule,  and 
put  out  bonds — ^perhaps  under  a  blanket  mortgage — 
bearing  a  low  rate  of  interest  for  less  than  their  par 
value.  Since  the  par  value  of  these  bonds  must  be 
paid  at  maturity,  the  shareholders,  if  they  wish  to  pro- 
tect themselves  against  the  discount,  may  ask  that  this 
discount  be  prorated  over  the  number  of  years  to  the 


6  Corporation  Finance 

maturity  of  the  mortgage  and  a  proportion  be  deducted 
from  the  net  earnings  each  year.  The  tendency  to 
relieve  the  present  by  a  sacrifice  of  the  future  is  nat- 
ural, but  cannot  be  defended  on  abstract  grounds.  For 
example,  a  company  which  might  float  a  five  per  cent, 
bond  at  par  chooses  to  issue  a  four  per  cent,  bond  at 
(let  us  say)  80.  Of  course,  to  raise  a  certain  amount 
of  money  it  must  then  increase  the  issue  by  twenty-five 
per  cent.  If  a  million  of  dollars  is  needed,  the  com- 
pany must  put  out  $1,250,000  of  bonds  at  80  to  obtain 
the  required  sum  ;  the  interest  to  be  paid  annually 
meanwhile  being  the  same  as  though  five  per  cent, 
bonds  had  been  issued  at  par.  Manifestly,  though, 
such  an  issue  requires  the  payment  of  $250,000  extra 
principal  at  maturity,  an  amount  which  might  be  pro- 
rated over  the  number  of  years  till  maturity  and 
deducted  each  year  from  income.  That  would  at  least 
serve  to  remind  shareholders  of  the  real  expense  of 
such  a  method  of  financiering,  even  when  thought  to 
be  made  necessary  by  circumstances.  The  course  of 
the  lyouisville  and  Nashville,  since  1894,  i^  this  very 
matter  deserves  commendation.  One  of  the  reasons  for 
such  issues  at  a  discount  is  that  investors  like  to  buy  a 
bond  selling  a  little  less  than  par,  because  it  offers  a 
better  chance  for  an  increase  in  value  than  a  bond  sell- 
ing at  a  premium.  If  it  requires  a  rate  of  interest  far 
above  the  ruling  market  rate  to  enable  the  issue  to  fetch 
par,  it  is  a  proof  that  the  amount  of  principal  asked  for 
is  too  large  for  the  business  to  support. 

To  issue  bonds  or  commercial  paper  at  too  high  a 
rate  of  interest  or  at  too  great  a  discount  from  the  face 
value,  except  for  special  reasons,  is  a  violation  of  the 
principle  upon  which  modern  industrial  debt  financier- 
ing is  based.     As  we  have  seen,  this  principle  is  that 


Bonds  and  Stocks  7 

as  large  a  part  of  the  required  capital  must  be  borrowed 
at  as  low  a  rate  of  interest  as  will  enable  the  partners 
in  the  enterprise  to  use  those  borrowings  in  their  busi- 
ness with  safety  and  at  a  profit  to  themselves.  If  the 
partners  or  shareholders  of  a  new  enterprise  are  not 
willing  to  contribute  the  necessary  money  beyond  this 
secure  proportion,  there  is  something  doubtful  about 
the  outcome.  What  has  been  said  about  firms  applies 
with  changed  circumstances  and  names  to  corporations. 
They,  too,  must  borrow,  though  their  borrowings  may 
take  the  form  of  a  mortgage  rather  than  that  of  com- 
mercial paper.  We  occasionally  read  of  a  stuface  rail- 
way or  other  company  which  has  no  bonds  upon  its 
property,  but  only  shares.  If  the  enterprise  is  at  the 
beginning  so  doubtful  that  borrowed  money  would  en- 
danger success,  the  promoters  do  well  to  take  all  the 
risk,  providing  they  have  faith  in  the  outcome.  But 
in  the  case  of  a  corporation  starting  with  something 
assured,  or  where  experience  has  demonstrated  that 
there  is  a  margin  of  safety,  to  avoid  borrowing  may 
not  be  good  financiering.  A  street  electric  railway 
paying  six  per  cent,  on  its  stock  could  sell  bonds  up  to 
half  of  its  capital  on  a  basis,  we  will  say,  of  five  per 
cent,  interest.  By  issuing  such  bonds  it  could,  on  the 
same  earnings,  pay  seven  j)er  cent,  instead  of  six  per 
cent,  on  its  capital  stock.  Every  profitable  corporation, 
if  it  so  decides,  may  rightly  take  all  the  advantage 
possible  of  these  principles  in  the  management  of  its 
finances. 

The  shareholders  in  a  corporation  are  the  partners  ; 
they  take  the  risks  of  the  business,  and  are  not  only 
entitled  to  all  profits  but  may  rightly  increase  those 
profits  by  every  legitimate  means.  It  is  also  a  business 
question  whether  the  share  capital  should  be  subdivided 


8  Corporation  Finance 

into  classes  with  a  preference  of  one  class  over  another. 
In  the  cases  of  certain  trading  or  manufacturing  com- 
panies no  bonds  are  issued,  the  capital  being  divided 
into  one  or  more  classes  of  preferred  shares  together 
with  common  stock.  The  corporation  of  H.  B.  Claflin 
Company  in  New  York  City  is  an  instance  in  point. 
This  company  was  formed  in  1890  to  take  over  the  dry- 
goods  jobbing  business  of  H.  B.  Claflin  &  Co.  It  has 
a  capital  of  $9,000,000,  divided  into  first  preferred 
stock,  bearing  cumulative  dividends  of  five  per  cent., 
second  preferred  stock,  bearing  cumulative  dividends 
of  six  per  cent.,  and  common  shares  covering  nearly 
one  half  of  the  capitalization.  In  such  cases  the  higher 
shares  should  have  the  preference  not  only  in  divid- 
ends, but  in  claims  upon  the  assets  ;  in  return  for 
which  privilege  they  are  limited  to  a  certain  but  com- 
paratively small  rate  of  dividend  annually.  Such  shares 
usually  carry  a  cumtdative  claim  as  against  the  other 
classes,  which  means  that  a  dividend  passed  at  any  one 
quarter  or  year  must  be  made  up  from  future  earnings 
before  the  lower  shares  receive  any  return.  Under  such 
circumstances  these  preference  stocks  really  take  the 
place  of  bonds,  and  are  to  be  so  considered  in  theory. 
Their  advantage  over  bonds  lies  in  this,  that  in  years 
of  extreme  depression  or  of  great  trade  losses,  suspens- 
ion of  preference  payments  does  not  involve  fore- 
closure and  loss  to  the  common  stock,  because  time  is 
allowed  in  which  to  make  up  such  losses.  In  the  cases 
of  corporations  formed  to  take  over  trading  or  manu- 
facturing concerns  in  whose  busines«  violent  fluctu- 
ations are  possible,  the  issue  of  preference  stocks 
instead  of  bonds  is  to  be  commended  ;  but  with  com- 
panies whose  business  may  reasonably  be  called  stable, 
bonds  are  in  better  faypr.     In  both  i;nstances  much  4^- 


Bonds  and  Stocks  9 

pends  upon  the  management,  but  the  average  investor 
seems  to  think  himself  more  secure  where  annual  pay- 
ments of  interest  are  obligatory  ;  he  believes  that  a  lit- 
tle pressure  upon  the  management  has  often  a  good  effect. 

In  the  United  States  the  majority  of  preference  shares 
in  the  hands  of  the  public  represent  eqtdtable  claims 
upon  future  or  present  prosperity.  They  were  generally 
issued  by  the  railways  as  evidences  of  debt  which  the 
exigencies  of  the  times  required  should  be  deferred  ; 
perhaps  some  peculiar  obligation  not  then  easily  paid  ; 
but  more  probably,  such  preferred  shares  were  given  to 
old  bondholders  who  were  compelled  by  insolvency  to 
yield  something  of  the  principal  and  interest  of  their 
then  debt.  In  1888  the  Chesapeake  and  Ohio  Railway 
was  reorganized  without  foreclosure,  the  bondholders 
consenting  to  readjust  their  claims.  The  *'  B  ''  bonds 
of  the  old  company  (bearing  six  per  cent.),  dated  1878, 
were  exchanged  for  two  thirds  of  their  face  value  into 
new  five  per  cent,  bonds,  and  for  one  third  into  first 
preferred  stock.  The  company  becoming  more  pros- 
perous, this  first  preferred  stock  was,  in  1893,  ex- 
changed two  thirds  into  **  blanket "  four  and  a  half  per 
cent,  bonds,  and  one  third  into  common  stock.  This 
process  relieved  the  needs  of  the  company  at  the  time, 
while  afterwards  the  holders  of  old  *'  B  ''  bonds  received 
more  than  the  value  of  their  original  investment. 

The  Lake  Superior  and  Mississippi  Railroad  was 
sold  under  foreclosure  in  1877  to  the  holders  of  its 
first  mortgage  bonds,  who  exchanged  their  bonds  into 
preferred  shares  at  the  rate  of  $1200  of  such  shares  for 
each  bond  of  $1000.  The  new  company,  the  St.  Paul 
and  Duluth,  thereupon  issued  a  new  first  mortgage, 
bearing  five  per  cent.  In  time  a  second  mortgage  was 
put  upon  the  property  for  extensions  and  improve- 


lO  Corporation  Finance 

ments.  Under  this  policy  the  necessities  of  the  situ- 
ation were  met,  and  after  1883  the  course  of  the  old  first 
mortgage  holders  was  justified  by  the  receipt  of  regu- 
lar dividends  upon  the  preferred  shares  ;  without  such 
concession  the  loss  to  such  holders  would  have  no 
doubt  been  almost  total. 

Though  no  stronger  for  these  reasons  legally,  prefer- 
ence stocks  issued  to  represent  deferred  claims  embody 
an  ethically  good  claim  upon  the  general  or  future 
prosperity. 

At  other  times  companies  having  only  common 
shares  may  like  to  exchange  a  part  in  certain  propor- 
tions for  preferred.  In  such  cases  the  motive  is  often 
sentimental ;  the  company  may  be  earning  a  small  sum 
over  fixed  charges  (bond  interest,  rentals,  and  taxes), 
a  sum  too  small  for  division  among  a  large  number  of 
common  shares,  but  enough  to  pay,  perhaps,  four  per 
cent,  on  a  small  preferred  capital.  It  is  considered 
better  to  pay  that  four  per  cent,  if  the  capital  is 
arranged  so  as  to  allow  of  it,  because  such  payment,  or, 
in  fact,  any  honest  pa3rtnent  of  dividends,  improves  the 
credit  of  the  company  in  the  eyes  of  the  public.  Senti- 
ment is  an  important  factor  in  corporation  financiering, 
one  of  which  the  good  manager  will  make  legitimate 
use.  It  is,  however,  an  abuse  of  sentiment  where  divid- 
ends not  fairly  earned  are  paid  in  order  that  the  credit 
of  the  corporation  may  have  a  fictitious  support.  The 
declaration  of  dividends  on  the  preference  B^ai&'of  the 
Philadelphia  and  Reading  in  1893,  followed  a  month 
later  by  the  bankruptcy  of  the  company  and  the  placing 
of  the  property  in  the  hands  of  receivers,  is  open  to  the 
above  criticism.  An  exception  to  this  statement  should 
be  made  in  cases  where  a  succession  of  prosperous 
years  is  followed  by  a  period  of  losses ;    if  recovery 


Bonds  and  Stocks  1 1 

seems  fairly  in  sight,  it  is  proper  to  continue  such  divid- 
end payments  for  a  while  rather  than  destroy  the  con- 
tinuity of  such  returns  to  shareholders.  An  instance  is 
that  of  the  Chicago,  Burlington,  and  Quincy,  a  company 
which  suffered  severe  losses,  in  1888,  through  a  strike 
among  its  enginemen.  Though  confessedly  not  having 
earned  it,  the  company  paid  the  dividend,  and  was 
under  the  circumstances  justified  in  so  doing.  The 
statements  made  regarding  the  stocks  and  bonds  of 
railway  companies  are  true  also  as  to  the  bonds  and 
stocks  of  other  corporations,  though  changes  must  be 
made  to  meet  the  circumstances  of  each  case. 

In  instances  where  large  corporations  have  been 
formed  for  the  prosecution  of  enterprises  which  demand 
large  plants  and  extensive  organizations  for  the  carry- 
ing on  of  the  business,  the  same  remarks  may  be  made 
without  much  modification.  Such  extensive  companies 
formed,  say,  for  the  manufacture  of  certain  particular 
articles  in  much  demand,  require  the  expenditure  of 
large  sums  of  money  for  special  machinery  and  for  the 
erection  of  buildings  specially  designed  for  the  purpose 
of  the  business.  This  plant  and  machinery  n;ay  be 
almost  valueless  for  any  other  purpose  than  for  this 
particular  manufacture.  Bonds  issued  by  such  a  com- 
pany are,  like  railway  mortgages,  really  dependent 
upon  the  success  of  the  corporation  and  its  business, 
since  usually  the  amount  of  such  bonds  is  largely  in 
excess  of  the  value  of  the  land  and  machinery  if  sold 
for  any  other  than  the  original  purpose  of  manu- 
facturing. The  difference  between  the  valuation  of 
the  plant  at  forced  sale  and  the  amount  for  which  it  is 
bonded,  represents  the  good- will  of  the  business,  whether  \__^ 
it  is  so  stated  in  the  company's  accounts  or  not.  It 
does  not  alter  the  case  to  say  that  the  amount  of  the 


12  Corporation  Finance 

bonded  indebtedness  (or  preferred  stock)  has  really 
been  expended  by  the  company  upon  its  property.  The 
lien  is  not  so  much  upon  the  property  itself  as  upon  the 
business  success  of  the  company.  Yet  that  success  may 
be  so  reasonably  sure  that  it  may  properly  form  the 
basis  for  borrowing  at  a  low  rate  of  interest.  Those 
who  have  knowledge  of  the  particular  line  of  manu- 
facturing which  the  new  company  is  to  pursue,  may  be 
clear  in  their  judgment  that  the  success  of  the  com- 
pany will  be  beyond  a  peradventure.  Yet  for  the  in- 
vestor or  for  the  banks  or  for  the  capitalist  generally, 
nothing  can  take  the  place  of  experience  as  the  basis 
of  a  judgment  as  to  corporation  values.  When  a  com- 
pany has  been  running  long  enough  to  enable  the  or- 
dinary lender  of  money  to  form  such  a  judgment,  he 
is  usually  willing  to  grant  the  company  a  larger  pro- 
portion of  credit  than  was  at  first  obtainable. 

The  fact,  however,  that  at  first  only  a  comparatively 
small  proportion  of  the  required  capital  could  be  bor- 
rowed at  ordinary  rates  of  interest  may  have  led  the 
promoters  of  such  enterprises  to  try  to  borrow  a  still 
larger  sum,  with  the  result  that  the  extra  risk  as  esti- 
mated by  the  banking  houses  is  paid  for  during  the 
whole  life  of  the  bonds  by  an  unusually  high  rate  of  in- 
terest, or,  which  is  the  same  thing,  by  a  heavy  discount 
from  the  par  value  of  the  bonds  issued.  An  instance 
of  such  a  discount  is  afforded  by  a  prominent  railroad 
company.  This  company  issued,  in  1884,  ten-forty  ad- 
justment bonds,  bearing  six  per  cent.  These  bonds 
were  so  named  because  they  could  be  called  in  by  the 
company  at  no  and  cancelled  ten  years  from  date,  be- 
coming due  in  forty  years.  These  bonds,  after  first 
being  offered  to  the  shareholders,  were  sold  at  57  J^  with 
a  bonus  of  stock  at  22^^ .  In  other  words,  for  $800  in  cash 


Bonds  and  Stocks  1 3 

the  purchaser  received  one  $1000  adjustment  bond  and 
$1000  in  stock  at  par.  Thus  the  bonds  practically  cost 
the  purchaser  $57^  each.  The  then  managers,  rep- 
resenting foreign  stockholders,  finding  the  company 
pressed  for  ready  money  to  take  up  called  loans  (tem- 
porarily, as  it  turned  out),  thought  themselves  com- 
pelled to  offer  such  severe  terms  ;  the  situation  hav- 
ing become  acute  through  mistakes  in  financial  policy 
in  previous  years.  The  credit  of  the  company  having 
meanwhile  greatly  improved,  these  bonds  were  paid  in 
10  years.  The  conversion  of  the  Atchison  incomes  into 
**  A  *'  and  '*  B  ''  bonds  in  1892  is  an  illustration  of  the 
mortgaging  of  future  prosperity  to  relieve  present  needs 
for  money.  Such  extra  interest  or  discount  is  a  meas- 
ure of  the  badness  of  the  financiering  or  of  the  pressure 
of  necessity,  and  in  times  of  depression  may  even  cause 
such  a  financial  pressure  of  annual  charges  as  in  effect 
to  be  a  reason  for  bankruptcy.  When  we  hear  it 
stated,  as  we  sometimes  do,  that  a  particular  business 
cannot  bear  the  high  rates  of  interest  which  it  is  directly 
or  indirectly  paying,  we  may  rightly  assume,  in  the 
absence  of  some  other  oppressing  cause,  that  the  reason 
for  the  present  distress  goes  back  to  the  time  when  the 
promoters  of  the  enterprise  or  the  organizers  of  the 
newly  incorporated  company  formed  to  take  over  an 
old  business,  were  unwilling  to  accept  the  estimate  of 
experienced  money-lenders  upon  the  success  of  the 
company.  Either  by  advancing  their  own  money  or 
by  inducing  others  to  become  partners  in  the  enter- 
prise, they  ought  to  have  obtained  share  capital  enough 
so  as  to  have  started  the  enterprise  conservatively  ;  one 
important  element  of  this  conservatism  being  that 
only  so  much  money  should  be  borrowed  as  could  be 
obtained  on  favorable  terms. 


14  Corporation  Finance 

In  the  cases  of  comparatively  small  corporations 
formed  for  trading  purposes  or  to  prosecute  a  business 
comparatively  small  in  volume,  care  must  be  exercised 
by  both  organizers  and  lenders  of  money.  The  bonds 
of  such  corporations  are  not  eagerly  sought  for  from 
the  nature  of  the  case.  Sometimes,  as  has  been  already 
remarked,  the  financiering  of  such  corporations  is 
accomplished  by  the  issuing  of  preferred  stocks  instead 
of  bonds.  So  far  as  the  general  public  is  concerned, 
the  borrowing  of  money  on  the  part  of  such  small  com- 
panies does  not  differ  greatly  from  the  procedure 
observed  in  the  borrowing  of  money  on  commercial 
paper  by  partners.  But  few  of  the  bonds  of  these  small 
companies  reach  the  public  ;  the  principal  source  of 
supply  for  borrowings  being  the  banks.  The  banks 
in  lending  money  to  these  small  corporations  require 
statements  from  them  the  same  as  in  the  cases  of  firms  ; 
but  because  of  the  difference  in  responsibility  between 
partners  and  corporations,  lending  institutions,  in  addi- 
tion to  the  claim  upon  the  assets  of  the  company,  usu- 
ally demand  the  personal  endorsement  of  the  officers, 
thus  in  effect  securing  from  such  small  companies  the 
personal  liability  of  the  managers  precisely  as  though 
the  business  were  the  property  of  an  individual  or  a 
firm. 

Municipal  bonds  form  an  exception  to  the  rules  of 
borrowing  according  to  the  probability  of  successful 
business.  A  municipality  is  any  territorial  subdivision 
of  a  country,  city,  county,  village,  or  township,  which 
may  wish  to  borrow  money  for  any  improvement  allowed 
by  law.  The  security  for  such  borrowings  does  not  rest 
primarily  upon  business  profits  but  upon  the  property 
embraced,  though  in  the  long  run  property  valuations 
in  any  city  or  county  must  depend  upon  the  prosperity 


Bonds  and  Stocks  1 5 

of  the  community.  Usually  the  power  to  bond  the 
town  is  limited  by  law  to  an  amount  covering  so  small 
a  percentage  of  the  town  values  that  the  question  of 
the  security  of  such  bonds,  from  the  point  of  view  of 
the  sufi&ciency  of  the  property  pledged,  does  not  often 
arise. 

On  this  account  municipal  bonds,  when  they  are 
good,  are  very  good  indeed,  and  command  high  prices 
at  the  hands  of  a  special  class  of  investors,  such  as  sav- 
ings banks  and  insurance  companies.  The  dangers  of 
municipal  bonds  arise  from  another  quarter.  The  ques- 
tions of  legality  of  issue  are  so  complex,  and,  as  even 
after  able  legal  opinions,  unexpected  difficulties  may  be 
encountered,  their  purchase  becomes  a  matter  of  some 
risk,  including  perhaps  a  long-contested  lawsuit,  in 
cases  where  counties  and  towns  may  for  any  reason 
desire  to  repudiate  their  obligations.  For  these  reasons, 
cities  enjoying  good  credit  can  sell  their  bonds  at  the 
lowest  rate  of  interest  known  in  financial  circles  ;  while 
as  for  the  bonds  of  other  less  known  municipal  divis- 
ions, only  such  institutions  as  have  unlimited  resources 
for  investigation  and  for  the  enforcement  of  the  pay- 
ment, if  found  necessary,  become  the  purchasers.  In 
general,  municipal  bonds  are  not  favorite  forms  of  in- 
vestment with  the  average  capitalist. 


CHAPTER  II 

FORMS  OF  CORPORATE  KN'TKRPRIS^ 

WHEN  a  firm,  established  long  enough  to  give  its 
returns  some  stability,  desires  to  sell  its  busi- 
ness, it  soon  finds  that  the  easiest  way  to  accomplish 
this  result  is  by  incorporation.  When  the  company  is 
decided  upon  or  formed,  the  bonds  or  shares  become 
Available  for  public  sale  or  subscription  in  any  desired 
amounts.  In  this  way  a  large  business  with  its  plant 
can  be  sold  by  piecemeal,  as  it  were,  at  a  total  valu- 
ation which  could  not  be  obtained  in  any  other  way. 
The  larger  the  business  the  more  difficult  is  it  to  find 
partnership  purchasers. 

The  usual  course  in  such  matters  is  to  consult  some 
banking  or  promoting  house  which  can  be  induced  to 
finance  the  project  (/.  ^.,  to  furnish  any  money  required 
during  the  transfer),  and  which  has  facilities  for  dis- 
posing of  the  new  bonds  or  shares  to  its  customers  and 
the  public.  It  is  a  tendency  of  the  times  to  give  the 
sale  of  public  securities  into  the  hands  of  those  whose 
profession  is  that  of  judging  of  the  values  of  the  securi- 
ties to  be  offered.  The  majority  of  the  investors  have 
their  own  concerns  to  look  after,  and  in  any  case  are 
not  good  judges  of  bonds  or  shares  or  of  the  prospects 
of  success  of  special  enterprises.  Such  persons  in  the 
end  take  the  advice  of  trusted  banking  houses.  Since 
the  reputation  of  such  houses  is  very  important  to 

i6 


Forms  of  Corporate  Enterprise  1 7 

them,  they  take  pains  not  to  recommend  purchases 
which  may  involve  their  customers  in  losses.  Con- 
versely their  recommendation  is  much  sought  after  for 
new  enterprises,  and  to  pay  their  charges  is  the  cheap- 
est way  in  the  long  run  to  ' '  float ' '  a  public  corpora- 
tion. These  remarks,  of  course,  do  not  apply  to  cases 
where  all  of  the  new  capital  is  retained  by  the  old 
partners. 

Where  such  houses  are  consulted  by  the  would-be 
incorporators  there  is  usually  a  difference  as  to  the 
value  to  be  put  upon  the  enterprise  ;  the  owners  are 
perhaps  over-sanguine ;  the  banking  house,  if  conserv- 
ative, goes  through  the  submitted  facts  and  figtu-es  in 
cold  blood.  It  knows,  too,  approximately,  what  the 
public  will  be  willing  to  pay.  The  capitalization  is 
then  fixed  at  a  sum  which  it  is  supposed  will  allow  of  a 
small  distribution  of  profits  even  in  poor  years. 

There  is  first  the  division  of  the  capital  into  bonds 
(or  preferred  stock)  and  common  shares.  In  order  that 
money  may  be  borrowed  at  the  lowest  rate  of  interest, 
and  thus  every  possible  profit  be  reserved  for  the  com- 
mon stock,  it  is  necessary  that  bonds  should  be  issued 
only  to  the  minimum  value  of  the  property.  When 
preferred  stock  has  a  preference  not  only  as  to  divid- 
ends but  also  as  to  assets  in  cases  of  failure,  it  takes 
the  place  of  bonds  and  should  be  regarded  in  the  light 
of  a  debt.  What  this  minimum  value  is,  is  not  an  easy 
question  to  determine.  Sometimes  it  is  taken  to 
include  the  values  of  the  buildings,  machinery  (or 
other  contents),  and  the  raw  material  on  hand  or  in 
process  of  manufacture.  Whether  this  is  safe  depends 
in  part  upon  the  nature  of  the  business.  Sometimes 
real-estate  experts  are  asked  to  appraise  the  plant  as  a 
basis  for  bonds  :  but  here  care  should  be  taken  as  to 


1 8  Corporation  Finance 

the  instructions  given  to  such  appraisers.  If  they  are 
required  to  give  an  opinion  on  the  value  of  the  ground, 
buildings,  etc. ,  for  the  use  of  that  particular  business, 
they  may  honestly  put  their  appraisal  at  figures  far 
above  anything  which  could  be  obtained  at  forced  sale 
in  case  of  insolvency,  and  security  in  such  an  event  is 
the  very  thing  sought  for  by  the  bondholder.  In  the 
same  way  and  under  similar  instructions  an  extrava- 
gant valuation  may  be  put  upon  the  machinery,  which 
may  not  be  new,  and  indeed  may  already  be  in  process 
of  supersedure  as  to  kind  in  other  and  competing  estab- 
lishments. The  raw  or  half- worked  up  material  should 
be  also  computed  at  prices  which  allow  for  possible 
fluctuations  because  of  changes  in  fashions  or  by  reason 
of  any  circumstances  which  may  affect  the  particular 
business  under  consideration.  Yet  bonds  aggregating 
a  larger  sum  than  the  valuation  of  the  plant  at  forced 
sale  may  be  legitimate  and  safe  because  of  the  stable 
nature  of  the  manufacturing  or  trading  to  be  taken 
over  by  the  new  company.  But  in  such  cases  it  should 
be  distinctly  understood  that  a  part  of  such  bonded 
debt  rests  for  security  upon  success  rather  than  upon 
real-estate  values,  z.  e.,  upon  the  *'  good- will." 

The  amount  of  common  stock  to  be  issued  does  not 
occasion  so  much  trouble.  Allowing  for  the  ups  and 
'  downs  of  business,  the  common  capital  should  fairly 
represent  the  fluctuating  possibilities  of  the  new  con- 
cern. To  estimate  this  future  properly,  the  ntunber  of 
common  shares  should  be  conservatively  small ;  but  the 
difficulty  here,  as  ever3rwhere  else  in  corporation  finan- 
ciering, is  the  dislike  of  the  public  to  the  payment  by  a 
corporation  of  dividends  higher  than  the  normal  rate  of 
interest.  It  is  better  financiering  to  pay  good  returns 
in  good  years,  thus  allowing  for  a  decline  in  periods  of 


Forms  of  Corporate  Enterprise  1 9 

depression,  than  to  capitalize  the  company  up  to  the 
highest  point  with  the  possible  result  of  making  the 
whole  common  issue  of  little  or  no  value  in  poor  years 
— and  worthless  shares  are  always  a  menace  to  honest 
business. 

In  asking  for  subscriptions  to  bonds  or  shares  in  a 
new  corporation  fonned  to  take  over  a  manufacturing 
or  trading  business,  it  is  usual  to  employ  reputable 
public  accountants  who  are  required  to  make  a  report 
stating  what  the  profits  have  been  for  a  number  of 
years.  These  accountants'  certificates  have  had  great 
weight  with  purchasers,  but  recent  events  have  limited 
their  importance.  Too  much  meaning  was  found  in 
such  certificates  by  small  capitalists  ;  they  were  con- 
strued practically  to  guarantee  the  whole  corporation 
and  its  future.  As  a  matter  of  fact,  those  certificates 
were  valuable  as  giving  an  expert  statement  of  the 
books  of  the  old  partnership  as  they  stood  ;  but  they 
were  not  intended  to  explain  or  to  sit  in  judgment  upon 
the  commercial  facts  which  lay  behind  those  books. 
Being  employed  by  the  old  partnership  or  by  the  pro- 
moting house,  such  accountants  may  have  examined 
only  such  accounts  as  they  were  requested  to,  made 
statements  in  the  form  desired,  or  omitted  items  which 
they  were  not  paid  to  investigate.  A  firm  of  account- 
ants might  certify  that  the  average  annual  profits  for 
three  years  were  a  given  sum,  and  stop  their  report  at 
that  point.  If  the  partners  had  a  year  previously 
formed  the  resolution  to  incorporate,  they  might  easily 
swell  their  revenues  greatly  during  the  last  year.  The 
discrepancy  would  be  detected  if  the  earnings  were 
given  for  each  year  separately,  but  not  if  an  average 
alone  were  stated.  Again,  the  form  of  such  a  certificate 
might  be  that  the  accounts  and  bills  receivable  ex- 


20  Corporation  Finance 

ceeded  those  payable  by  a  given  sum  which  might  be 
added  to  the  assets  to  be  covered  by  the  proposed  share 
capital ;  and  such  a  statement,  while  true,  might  be 
misleading.  The  accounts  receivable  might  be  such  as 
were  always  outstanding,  for  which  working  capital 
should  be  provided  in  the  plan  of  capitalization.  If  so, 
and  every  business  needs  more  or  less  of  such  working 
sums  of  money,  simply  to  offset  them  by  bills  payable 
— meaning  money  borrowed  from  the  banks — is,  under 
the  circumstances,  manifestly  improper.  Borrowed 
money  is  a  debt,  and  the  plan  of  incorporation  under 
discussion  assumes  that  the  bonds  or  preferred  stock 
covers  the  whole  of  that  debt.  This  particular  error  in 
incorporating  is  sometimes  ventured  upon  in  order  to 
give  to  the  old  partners  all  the  money  subscribed  by 
the  public  for  the  bonds  and  common  stock,  but  it  con- 
ceals the  real  status  of  the  finances  and  leaves  un- 
guarded a  possible  danger.  Moreover,  bills  payable 
must  be  met  in  full  while  the  running  accounts  of  cus- 
tomers may  not  be  worth  their  face,  leaving  a  deficiency 
not  covered  by  such  a  plan  of  incorporation.  The  rise 
and  fall  of  the  Thurber-Whyland  Company  in  New 
York  City  furnishes  an  example. 

It  may  be  that  the  certificate  unintentionally  mis- 
leads in  another  way.  The  books  may  be  exact  in 
giving  the  earnings  and  expenses  for  the  previous 
year,  and  yet  the  resulting  profits  may  not  be  a  proper 
basis  for  corporate  capitalization  ;  for  the  reason  that 
selling  prices  may  have  been  exceptionally  high  or  the 
cost  of  raw  material  or  of  some  important  item  of  ex- 
pense exceptionally  low,  so  that  the  year's  profits  may 
be  too  good  for  an  estimate  of  the  future.  The  case  of 
the  AUsopp  Brewery  in  England  is  an  illustration. 
For  these  reasons,  the  course  for  those  proposing  to 


Forms  of  Corporate  Enterprise  2 1 

incorporate  themselves,  or  to  promote  such  incorpora- 
tion, or  to  purchase  the  bonds  and  shares  in  the  new 
company,  is  to  supplement  the  information  furnished  by 
the  accountant  with  other  expert  knowledge  regarding 
the  circumstances  and  conditions  under  which  the  par- 
ticular business  has  been  and  is  likely  to  be  carried 
on. 

A  matter  which  should  be  considered  is  that  of  man- 
agement. Practiced  experience,  as  well  as  the  best 
economic  theory,  lays  emphasis  upon  the  importance  of 
an  able  manager.  Nothing  can  take  his  place  ;  and 
his  rewards  in  the  shape  of  salary  or  returns  upon  his 
shares,  must  be  commensurate  with  his  importance. 
In  building  up  a  business  the  personal  element  is  a 
great  factor.  In  railways  there  has  been  developed  in 
the  process  of  time  a  body  of  specialists  who  are  trained 
in  their  work  of  superintending  and  managing  railroad 
operations,  and  from  whom  men  may  always  be  had  by 
any  company  to  take  control.  This  same  thing  will  in 
time  be  true  of  all  corporation  work  which  concerns 
the  production  or  distribution  of  staple  goods  or  neces- 
saries, and,  indeed,  this  is  true  already  of  certain  lines 
of  work  ;  but  it  is  a  point  to  be  considered  by  all  in- 
terested in  new  corporations  whether  expert  manage- 
ment can  be  had,  particularly  if  those  who  brought  the 
old  firm  up  to  its  place  of  importance  are  soon  to  drop 
out  of  control  through  age  or  lack  of  interest.  When 
our  important  corporations  have  passed  their  experi- 
mental stage,  proper  management  will  be  largely  a 
question  of  proper  payment. 

Aside  from  the  advantages  which  the  corporate  form 
offers  for  the  gathering  of  capital  in  small  sums  for 
some  great  enterprise,  for  the  massing  of  men  and 
machinery  at  some  proper  spot,  and  for  the  conduct  of 


22  Corporation  Finance 

a  large  business  at  a  small  expense  per  unit  of  output, 
there  are  benefits  to  other  and  smaller  concerns  by  the 
transfer  into  corporations.  It  often  happens  that  part- 
nerships are  turned  into  companies  without  intention 
to  become  public  concerns.  Perhaps  a  number  of  per- 
sons acquire  an  interest  in  a  business  established  and 
built  up  by  a  father  and  uncle,  a  business  which  it  is 
intended  to  keep  in  the  family.  But  the  multiplication 
of  owners  occasions  much  difiiculty,  while  another 
death  or  two  may  put  the  whole  enterprise  in  peril, 
perhaps  require  a  selling  out  to  other  parties  in  order 
to  determine  the  value  which  would  then  require  to  be 
divided.  These  perils  lying  in  the  path  of  firms  hav- 
ing many  partners,  some  minors,  some  women,  are  well 
understood.  Some  of  them  may  be  guarded  against  by 
such  devices  as  insuring  the  lives  of  the  managing  part- 
ners ;  but  many  of  such  instances  are  best  solved  by 
organizing  a  corporation  to  carry  on  the  business  ;  in 
this  way  the  proportion  of  each  partner  or  heir  can  be 
set  aside  in  shares,  which  can  be  transferred  or  sold  in 
any  proportion  or  at  any  price  without  affecting  the 
business  itself.  Nor  will  death  destroy  the  living  of 
the  remaining  owners  ;  for  corporations  do  not  die  with 
the  death  of  shareholders.  One  of  the  arguments 
against  trading  coporations  is  that  the  new  company 
may  lose  the  advantage  of  the  zeal  and  ability  of  the 
manager  who  has  brought  the  business  up  to  its  present 
state  of  profitableness,  but  who  having  now  no  such 
interest  in  the  result  will  drop  out  altogether,  or  will 
not  give  it  the  old  and  close  attention.  In  scattered 
instances  this  may  be  a  good  objection,  for  we  should 
not  omit  the  personal  equation  from  our  calculations. 
To  supply  a  class  of  managing  specialists  in  trading  or 
manufacturing  is  a  work  of  time  ;  but  if  a  particular 


Forms  of  Corporate  Enterprise  23 

line  of  trading  or  manufacturing  is  large  enough  to 
demand  expert  management  and  to  give  remunerative 
employment  to  those  who  will  study  the  business,  such 
a  clavSS  will  surely  arise  to  meet  that  demand.  The 
only  danger  is  that  until  a  good  manager  is  bom  and 
made,  the  business  may  suffer  to  a  certain  extent.  It 
is  proper  to  take  the  contingency  into  account  in  esti- 
mating on  the  probable  future  values  of  the  bonds  and 
shares  of  a  corporation  if  offered  for  public  subscription 
or  sale.  In  some  cases  the  contingency  may  be  provided 
for  by  arranging  to  have  the  old  managers  retain  a 
large  interest  for  a  certain  number  of  years,  or  in  any 
way  which  will  make  future  success  an  advantage  to 
the  old  partners. 

But  to  partners  who  form  a  company  for  family 
reasons,  these  possible  objections  do  not  apply.  The 
status  of  such  companies  is  directly  affected  by  the  fact 
that  no  bonds  or  shares  are  to  be  sold  to  the  public  ; 
therefore  the  public  are  concerned  with  the  success  or 
failure  of  such  a  family  company  only  so  far  as  that 
company  may  wish  to  borrow  money  from  the  banks 
or  ask  for  credit  on  goods  purchased.  In  such  cases 
equity  requires  a  complete  exhibit  of  their  affairs  to 
those  who  have  a  right  to  that  information.  For  the 
public  at  large,  and  for  the  information  of  the  state 
which  granted  the  charter  of  incorporation,  a  statement 
of  the  assets  and  liabilities  in  brief  form  is  properly 
demanded.  The  profits  of  a  family  company  is  not  a 
matter  with  which  the  state  need  concern  itself.  The 
limits  of  liability  under  a  corporate  form  are  well  under- 
stood, and  if  liability  is  limited,  so  also  is  the  credit ; 
no  undue  advantage  is  taken  of  anybody  by  incorpora- 
tion. Bank  officers  when  asked  for  loans  will  either 
accept  the  signature  of  the  company  through  its  proper 


24  Corporation  Finance 

representative,  or  will  demand  the  personal  endorse- 
ment of  some  individuals  ;  the  matter  of  credit  in 
family  corporations  regulates  itself. 

A  defect  in  our  general  laws  touching  corporations 
is  often  the  neglect  to  distinguish  between  those  com- 
panies which  are  public  in  their  nature  and  those  which 
are  private.  A  company  whose  bonds  or  shares  are 
held  by  the  public  and  which  depends  upon  public  sup- 
port for  its  financiering,  ought  to  be  compelled  (if  it 
does  not  agree  of  its  own  motion)  to  give  out  its  busi- 
ness accounts  in  such  detail  that  the  holders  of  its  bonds 
or  preferred  or  common  stocks  can  form  a  clear  idea  of 
the  profitableness,  of  the  financial  standing,  and  of  the 
managerial  success  of  their  company.  But  private  or 
family  companies  are  under  no  obligations  to  the  pub- 
lic as  to  their  affairs  except  as  already  noted,  and  should 
not  be  required  to  make  returns  in  detail.  The  distinc- 
tion between  public  and  private  corporations  would  at 
times  be  difficult  to  draw  ;  no  rule  could  be  made  which 
would  not  sometimes  err.  Perhaps  a  limit  to  the  num- 
ber of  stockholders  would  furnish  a  practical  test  under 
which  such  a  distinction  could  be  made. 

It  is  sometimes  thought  that  the  legal  restrictions 
imposed  upon  corporations  and  the  state  oversight  to 
which  they  are  subjected,  are  such  drawbacks  to  the 
corporate  form  as  to  balance  the  advantages  already 
referred  to.  Such  restriction  and  such  oversight  will 
probably  never  be  withdrawn  ;  indeed,  the  tendency 
of  the  times — as  evidenced  as  much  in  economic  discus- 
sion as  in  actual  legislation — is  toward  further  restraint. 
The  matter  of  stock  or  bond  watering  often  has  busi- 
ness effects  which  a  prolonged  strike  or  some  other 
commercial  event  can  alone  make  clear ;  the  whole 
discussion  as  to  **  monopoly,"  though  somewhat  crude 


Forms  of  Corporate  Enterprise  25 

as  yet,  may,  as  regards  future  legislation,  turn  in  the 
end  upon  the  question  whether  the  profits  arising  from  1 
combination  or  from  huge  corporations  have  been  equi- } 
tably  divided  between  the  three  parties  in  interest :  the ) 
company  itself,   the  consuming  public,   and  the  em-j 
ployees.     To  answer  such  a  question,  the  widest  in- 
formation will  be  necessary.     Corporations,  therefore, 
should  not  look  forward  to  any  general  reduction  in 
the  amount  of  state  regulation. 

But  while  this  seems  to  be  true  generally,  it  by  no 
means  follows  that  corporations  will  find  that  form  of 
doing  business  less  favorable  than  before.  If  we  keep 
in  mind  the  fact  that  a  corporation — a  public  company 
— implies  a  well-established  business  on  a  scale  so  great 
as  to  require  large  capital  and  a  large  and  well  equipped 
plant,  it  will  be  seen  that  the  best  success  cannot  come 
from  the  partnership  form.  If  we  accept  a  large  out- 
put or  traffic  and  a  correspondingly  low  cost  per  unit 
of  production  as  the  criterion  of  a  well-managed  com- 
pany, we  necessarily  imply  a  large  business  enjoying 
good  credit  and  with  years  of  experience  behind  it, 
things  which  are  not  so  hopefully  to  be  expected  from 
a  firm.  Such  a  company  must,  in  the  nature  of  the 
case,  have  an  element  in  its  business  which,  from  want 
of  a  better  word,  may  be  called  monopolistic  ;  if  that 
advantage  is  used  for  the  public  good  there  should  be 
no  complaint ;  it  is  an  advantage  in  the  hands  of  a  skil- 
ful manager  for  which  the  company  may  well  pay  by 
giving  publicity  to  its  affairs.  Nor  should  it  be  forgot- 
ten that  in  such  cases  publicity  does  not  have  the  draw- 
backs urged  by  small  trading  companies — that  it  invites 
competition.  If  our  supposed  company  is  well  man- 
aged and  is  doing  business  at  a  low  ratio  of  profit, 
publication  of  its    affairs    rather    repels    competition 


26  Corporation  Finance 

by   showing    the    hopelessness  of  success  to  a  new 
company. 

Precisely  because  a  large  volume  of  transporting  or 
manufacturing  is  essential  to  the  stability  and  long- 
continued  success  of  an  ideal  corporation,  so  such  cor- 
porations tend  gradually  to  absorb  the  production  of 
such  articles  as  can  be  carried  or  manufactured  in 
large  quantities,  and,  of  course,  consumed  by  the  pub- 
lic in  like  amounts.  Generally  such  articles  are  the 
necessaries  of  Hfe,  or  if  not  strictly  speaking  neces- 
saries, then  those  with  which  the  consuming  public  are 
especially  concerned.  From  this  point  of  view  also  we 
must  expect  in  the  future  additional  legislation.  The 
best  defence  of  corporations  against  unduly  severe  laws 
is  full  publicity.  The  history  of  a  company,  its  early 
losses  and  struggles,  the  prices  of  the  commodity  when 
the  business  was  begun  compared  with  prices  now,  the 
cost  of  production  per  pound  or  gallon  or  barrel,  show- 
ing the  reduction,  and  in  view  of  such  facts  the  moderate 
profits  of  to-day — statements  such  as  these  will  prove  to 
be  the  best  defence  against  drastic  legislation  before  the 
bar  of  public  opinion.  But  a  company  relying  upon  such 
a  defence  must  be  sure  that  its  course  as  regards  prices 
and  policy  is  one  which  cannot  be  fairly  attacked. 
For  these  reasons,  while  the  restrictions  imposed  by 
the  state  are  sometimes  onerous  and  often  foolish,  yet 
the  advantages  of  the  corporate  form  for  the  prosecu- 
tion of  a  large  and  stable  business  must  outweigh  the 
disadvantages.  Probably  the  question  of  taxation  is  a 
serious  one  for  most  corporations.  Their  form  and 
their  business  seem  to  invite  taxation.  It  may  be  that 
for  a  time  corporations  will  be  obliged  to  carry  more 
than  their  proportionate  share  of  the  common  burden 
in  this  respect.     In  the  end  this  question  will  run  into 


Forms  of  Corporate  Enterprise  2  7 

the  more  general  one  of  the  rightful  profits  to  be  made; 
but  meanwhile  taxes  are  things  for  which  incorpora- 
tions must  be  prepared. 

Corporations  formed  to  carry  on  a  business  semi- 
public  in  its  nature,  like  that  of  supplying  water  and 
gas  to  the  citizens  of  cities  and  towns,  do  not  need 
extended  discussion.  So  far  as  the  arrangement  of 
their  finances  is  concerned,  it  should  not  depart  greatly 
from  the  principles  already  laid  down  for  the  formation 
of  manufacturing  companies.  Into  the  matter  of  gov- 
ernmental ownership  it  is  not  purposed  to  enter  here  ; 
but  regarded  from  the  financial  point  of  view  the 
amount  of  bonded  indebtedness  should  not  exceed  the 
safe  value  of  the  property  conservatively  estimated. 
Gas  and  water  companies  do  not  indeed  often  offend  in 
these  particulars,  since  in  successful  cases  the  shares 
have  so  increased  in  value  as  to  leave  no  doubt  of  the 
conservatism  of  the  original  financial  plan.  The 
investor  should  look  into  the  probability  of  losses  by 
reason  of  a  change  in  policy  on  the  part  of  the  com- 
munity, or  because  of  the  beginning  of  the  enterprise 
on  a  scale  of  expenditure  not  warranted  by  the  prob- 
abilities. Yet  water  and  gas  are  modem  necessaries 
of  life,  and  the  supplying  of  these  necessaries,  when 
done  by  private  companies  under  a  conservative  plan, 
is  a  proper  and  safe  business  for  the  investment  of 
money. 

Another  form  of  industrial  enterprise  destined  to 
assume  an  important  position  in  investment  finance,  is 
that  of  supplying  street  transportation  to  the  inhabit- 
ants of  cities  and  towns.  The  rapid  growth  in  the 
use  of  electrical  power  has  carried  the  matter  of  surface 
railways  in  and  between  cities  and  villages  to  a  posi- 
tion of  great  importance.     As  forming  the  basis  for  the 


28  Corporation  Finance. 

investment  of  capital  there  can  be  nothing  better  than 
the  street  traffic  of  our  cities.  Experience  has  demon- 
strated that  such  traffic  is  even  more  constant  and 
stable  than  that  of  steam  railroads,  and  is  capable  of 
yet  greater  development,  as  surface  car  lines  are  ex- 
tended to  meet  the  demands  of  a  spreading  population 
and  as  travel  increases  in  proportion  as  the  facilities 
of  easy  and  rapid  transit  are  increased. 

But  while  the  safety  of  street  travel  as  a  basis  for 
the  investment  of  capital  cannot  be  disputed,  there 
may  remain  questions  about  the  values  of  the  bonds 
and  shares  of  individual  street  railway  companies  for 
whose  settlement  further  time  is  required.  Some  six 
or  eight  years  ago  the  motive  power  of  street  lines 
was  the  horse;  but  electricity,  it  was  soon  found, 
upset  all  the  old  calculations  of  receipts  and  expenses. 
The  capitalization  of  the  company  was  increased  by 
the  cost  of  the  new  power  but  so  was  the  volume  of 
travel,  so  that  great  profits  were  shown  to  have  been 
earned. 

The  demand  for  electric  equipment  led  to  its  manu- 
facture in  such  quantities  and  under  such  uniformity 
of  detail  that  the  prices  of  new  motors  and  the  like  fell 
to  one  half  the  old  figures.  Study  and  experience 
found  ways  of  keeping  rolling  stock  and  motors  in 
repair  at  a  cost  formerly  believed  impossible ;  and 
meanwhile  the  traffic  receipts  continued  to  increase 
steadily  and  regularly  as  the  public  came  to  realize 
the  improvements  in  street  conveyance  and  to  take 
increasing  advantage  of  them. 

In  the  cases  of  companies  freshly  established  and 
operating  in  large  cities,  it  may  be  assumed,  for  the  pur- 
poses of  a  rough  calculation,  that  the  roadbed  will  re- 


Forms  of  Corporate  Enterprise  29 

quire  a  complete  renewal  in  ten  or  twelve  years,  the 
overhead  construction  (if  the  trolley  is  used)  within  fif- 
teen years,  the  electric  station  and  buildings  in  from 
twenty-five  to  fifty  years,  the  car  bodies  in  twelve  or 
fifteen  years,  and  the  motor  trucks  in  ten  or  twelve 
years,  with  the  steam  machinery  in  fifteen  years. 
These  averages  of  life  should,  of  course,  be  extended  in 
cases  where  circumvStances  would  make  such  a  test  too 
severe,  as,  for  instance,  in  interurban  lines  using  the 
turnpikes.  When,  however,  fair  averages  can  be  ob- 
tained and  the  cost  of  such  renewals  estimated,  it  will 
be  possible  for  those  interested  in  a  new  road  to  make 
a  hypothetical  calculation  of  the  average  annual  earn- 
ings for  the  future,  leaving  the  expected  increase  in 
trafiic  as  an  offset  to  any  possible  error  in  the  calcu- 
lation. 

We  are  now  accumulating  a  mass  of  experiences  and 
figures  about  street  railway  companies  which  will  place 
the  bonds  and  shares  of  those  companies  on  as  sure  a 
basis  as  those  of  steam  railroads  and  as  fully  entitled  to 
the  good  opinion  of  the  investing  public.  Meanwhile, 
an  approximate  result  can  be  obtained  by  any  one  who 
will  take  the  time  and  trouble  to  make  a  thorough 
analysis  of  the  condition  and  circumstances  in  any 
particular  case. 

A  matter  to  be  considered  also  is  the  life  of  the  char- 
ters of  the  street  companies  and  the  rights  to  the  use 
of  the  highway.  Generally  speaking,  the  American 
public  are  not  disposed  to  be  unfair,  and  a  practical 
seizure  of  street  railway  property  by  a  forfeiture  of  the 
charter  or  by  a  refusal  to  renew  the  same  without  com- 
pensation is  not  to  be  expected.  On  the  other  hand, 
it  is  often  a  matter  of  importance  how  far  the  company 


30  Corporation  Finance 

is  protected  against  competition  perhaps  on  adjoining 
streets.  It  is  well  also  to  examine  the  provisions  of  the 
charter  to  see  whether  they  contain  requirements  which 
may  prove  onerous  in  the  future. 

Throughout  this  book  the  form  of  corporation  dis- 
cussed is  that  of  the  company  whose  capitalization  rests 
directly  upon  the  property,  and  whose  shares  are  owned 
by  individuals.  There  is,  however,  a  company  of  an- 
other sort  formed  under  the  laws  of  certain  States,  par- 
ticularly New  Jersey,  which  permit  corporations  to  hold 
the  shares  of  other  corporations.  In  such  instances  the 
company  does  not  itself  hold  property  or  manage  a  busi- 
ness, but  issues  its  bonds  or  shares  upon  the  bonds  or 
shares  of  other  and  operating  companies  held  in  its 
treasury;  it  is,  in  short,  a  corporation  of  corporations. 

In  certain  lines  of  business  such  financing  companies 
are  the  logical  result  of  the  movement  toward  consolid- 
ation, of  which  the  simple  company  was  the  first  out- 
come. In  some  cases  no  other  method  of  concentration 
seems  possible.  Perhaps  the  production  of  some  article 
requires  that  the  various  processes  shall  be  conducted 
in  as  many  different  States  whose  laws  demand  that  the 
business  within  that  State  shall  be  conducted  by  a  com- 
pany incorporated  by  that  State.  If  all  these  sub- 
sidiary companies  are  to  work  in  harmony  there  must 
be  some  method  of  uniform  management,  brought 
about  most  easily  by  a  common  ownership  of  the  differ- 
ent shares.  Economically  speaking,  such  financing 
companies  are  to  be  judged  by  their  results,  precisely 
as  in  the  case  of  simple  corporations. 

Companies  are  sometimes  formed  to  hold  the  shares 
of  other  companies,  principally  to  prevent  competition 
and  to  stop  the  reduction  in  prices  that  perhaps  previ- 
ously to  such  common  ownership  was  bringing  disaster 


Forms  of  Corporate  Enterprise  3 1 

upon  all  concerned.  Financial  insolvency  is  a  thing  to 
be  dreaded  for  its  own  sake  ;  and  when  it  would  ap- 
parently lead  to  no  better  conditions  than  before,  it  con- 
fers no  benefit  upon  the  community.  Such  companies 
are,  as  before,  judged  by  their  ultimate  results,  society 
at  large  being  adverse  to  such  combinations  only  as 
they  may  prevent  genuine  progress  through  the  forma- 
tion of  still  larger  single  companies  able  to  reduce  costs 
to  themselves  and  prices  to  the  consumer.  Such  com- 
binations are  sometimes  made  through  Trust  agree- 
ments, which  purport  to  give  to  the  old  proprietors  in 
lieu  of  their  old  title,  a  trustee's  certificate  stating  that 
they  are  entitled  to  such  a  proportion  in  the  equity  of 
all  the  combined  businesses  as  their  original  property 
bore  to  the  whole,  these  various  values  being  previ- 
ously fixed  by  negotiations  between  those  concerned. 
The  public  at  large  are  hostile  to  such  Trusts,  believing 
them  to  be  secret  agreements  in  restraint  of  trade  and 
against  the  interests  of  the  community.  Moreover, 
they  appear  to  be  unnecessary,  since  all  the  essential 
advantages  of  a  Trust  can  be  secured  under  the  form 
of  a  lawful  corporation  either  simple  or  compound. 

Where  the  properties  sought  to  be  combined  have 
been  owned  by  firms  or  individuals,  it  has  often  been 
found  expedient  to  transfer  the  title  of  such  properties, 
perhaps  lying  in  different  States,  directly  to  the  com- 
bining company  in  return  for  the  issue  of  bonds  and 
shares  of  the  new  company  in  agreed  proportions.  In 
such  cases  the  possible  advantages  are  that  it  may  give 
to  the  new  company  the  knowledge  and  skill  possessed 
in  different  degrees  and  about  different  parts  of  the  pro- 
cess by  the  old  proprietors,  for  common  use  ;  that  it 
may  prevent  frauds  in  weight  and  quality  which  the 
previous  extreme  competition  may  have  brought  about ; 


32  Corporation  Finance 

and  that  it  may  allow  a  concentration  of  buying  and 
selling  at  the  least  expense  and  with  better  results.  If 
a  reasonable  share  of  these  advantages  is  given  to  the 
public  in  one  form  or  another,  the  new  company  has  a 
strong  argument  for  its  existence. 

As  to  the  finances  of  such  huge  corporations,  or  of 
companies  holding  the  shares  of  other  companies,  they 
do  not  differ  in  principle  from  the  rules  already  quoted 
regarding  simple  corporations.  The  bonds  issued  (in- 
cluding the  underlying  liens,  if  any)  should  not  exceed 
in  amount  the  minimum  worth  of  the  property,  and  the 
shares  should  fairly  represent  the  fluctuating  values 
remaining.  The  bonds  and  shares  of  such  great  com- 
bining corporations,  generally  speaking,  are  not  quoted 
on  the  exchanges  at  as  high  a  range  as  those  of  rail- 
ways. This  may  be  due  partly  to  the  fact  that  the 
business  of  the  company  may  be,  from  the  nature  of 
the  case,  highly  speculative  in  character,  and  therefore 
uncertain  as  to  results  in  any  particular  year  ;  or  its 
affairs  may  be  in  the  hands  of  men  perhaps  experienced 
in  that  particular  line  of  business,  but  who  have  not 
yet  acquired  a  reputation  with  the  investing  public  ;  or 
perhaps  there  may  be  on  its  board  of  directors  or  among 
its  officers  no  one  in  whom  capitalists  have  confidence 
as  experienced  in  financial  management,  for  the  depart- 
ment of  the  finances  in  corporation  affairs  requires 
special  care  and  ability  just  as  does  the  manufacturing 
or  trading.  Time  will  be  required  to  bring  about  a 
settled  public  opinion  as  to  the  degree  of  value  which 
can  safely  be  put  upon  the  businesses  of  huge  industrial 
combinations  or  corporations. 


CHAPTER    III 

RAII^WAY  BONDS 

WHEN  the  owner  of  a  dwelling-house  executes  a 
mortgage  upon  his  property  up  to  a  certain 
percentage  of  its  assumed  value,  the  transaction,  so  far 
as  the  financiering  is  concerned,  is  not  different  in 
theory  from  similar  transactions  when  entered  into  on 
a  larger  scale  by  corporations.  The  lender  of  the 
money  first  inquires  into  the  safety  of  his  loan.  He 
does  not  wish  to  become  in  effect  a  partner  with  the 
mortgageor  by  making  himself  dependent  even  to  a 
small  extent  upon  the  success  of  the  borrower  in  busi- 
ness. He  loans  the  borrower  a  sum  of  money  equal  to 
one  half  or  two  thirds  of  the  appraised  value  of  the 
dwelling-house,  considering  this  proportion  of  that 
value  as  secure  even  under  a  forced  sale.  Practically, 
therefore,  the  mortgageor,  as  in  the  case  of  corporations, 
borrows  money  at  a  comparatively  low  rate  of  interest 
upon  the  minimum  value  of  his  property.  If  the  sum 
asked  for  is  in  excess  of  these  percentages  of  the  value 
the  loan  is  refused,  or  if  accepted  is  taken  at  a  corre- 
spondingly high  rate  of  interest,  thus  violating  the 
principle  of  debt  financiering  already  discussed. 

Mortgages  upon  dwelling-houses  differ,  however,  in 
some  important  points  from  the  debts  due  by  corpora- 
tions.    The  lender  of  money  upon  ordinary  real  estate 
does  not  rely  for  security  upon  the  success  of  the  bor- 
3  33 


34  Corporation  Finance 

rower  in  business, — that  has  already  been  stated  ;  but 
neither  does  the  lender  rely  upon  the  profitableness  of 
the  profession  or  trade  in  which  the  mortgageor  is 
engaged.  The  reliance  is  rather  upon  the  business 
success  of  all  citizens,  with  allowances,  of  course,  for 
advances  or  reductions  in  values  of  real  estate  which 
may  come  from  the  shiftings  of  population  or  the 
caprices  of  fashion.  If  the  mortgageor  should  be  unable 
to  pay  the  interest  on  his  mortgage  when  due,  and  the 
property  should  be  offered  for  sale  under  foreclosure 
proceedings,  any  man  in  any  line  of  business  may 
become  the  purchaser.  In  short,  the  property  and  its 
value  is  not  dependent  upon  any  one  man  or  any  one 
trade,  but  upon  the  prosperity  of  the  whole  community. 
This  is  not  generally  the  case  with  large  corpora- 
tions. The  railway  lines  in  the  United  States,  for 
example,  vary  in  capitalization  from  $15,000  to  $200,000 
per  mile,  with  an  average  of  about  $50,000.  They  are 
bonded  for  an  average  of  $32,000  per  mile.  Railway 
lines  are  expensive  to  construct.  A  roadbed  must  be 
built  up  and  made  fit  to  bear  the  running  of  trains  ; 
the  erection  of  costly  bridges  and  other  works  must  be 
undertaken  ;  rails  and  ties  must  be  bought,  so  that  the 
railroad  properties  as  they  exist  to-day  could  not  be 
duplicated  for  the  amount  of  their  bonded  debt ;  yet  if 
the  trains  were  to  stop  running,  the  rails  and  ties  would 
be  worthless  except  for  old  iron  and  wood,  while  the 
right  of  way  could  be  sold  to  the  neighboring  farmers 
only  at  a  low  valuation  per  acre.  The  whole  property 
of  a  railroad  company,  considered  simply  as  real  estate 
and  old  material,  is  worth  but  a  small  fraction  of  the 
amount  for  which  it  is  mortgaged.  The  creditors  of 
the  company  depend  for  the  security  of  their  money 
not  upon  the  property  considered  as  such,  but  upon  the 


Railway  Bonds  35 

business  for  wliich  the  company  was  organized  ;  that  is, 
upon  the  transportation  of  passengers  and  goods.  If  that 
transportation  yields  a  profit,  the  bonds  are  safe,  other- 
wise not.  The  bondholders  cannot,  as  in  the  case  of  a 
dwelling-house,  hope  to  sell  the  property  to  any  com- 
panies except  those  engaged  in  transportation.  The 
American  law  and  the  wording  of  American  railway 
mortgages  state  the  lien  to  be  upon  the  property  ;  but, 
commercially  speaking,  this  is  not  correct ;  the  mort- 
gage is  really  upon  the  company's  revenues.  But  rail- 
way trains  must  continue  to  be  run.  Not  only  is  there 
a  public  duty  involved  which  forbids  the  State  to  allow 
the  stoppage  of  railway  working  except  in  extreme 
cases,  but,  since  the  value  of  the  bonds  depends  upon 
income,  the  operations  which  produce  that  income 
must  be  continued  even  though  the  result  be  in  part 
unfavorable  ;  otherwise  the  loss  would  be  total.  But 
since  railways  must  be  worked,  the  expenses  of  work- 
ing must  be  paid.  SufiScient  material  and  supplies 
must  be  bought,  the  claims  of  employees  for  wages 
must  be  met,  and  everything  reasonably  necessary  for 
the  proper  operation  of  the  railway  must  be  paid  from 
current  revenues.  It  is  seen,  therefore,  that  the  lien 
of  a  railway  bond  is  finally  shifted  from  the  real  estate 
to  the  gross  earnings  and  then  to  the  net  earnings  of ' 
the  company. 

The  statement  that  the  real  lien  of  a  railway  bond  is 
upon  the  commercial  success  of  the  company  as  a  carrier 
of  traffic  explains  some  of  the  anomalies  of  corporation 
practice.  The  railway  mortgage  repeats  in  the  strong- 
est legal  phrases  the  supposed  fact  that,  if  interest  or 
principal  is  not  paid  when  due,  or  if  any  other  pro- 
vision is  not  complied  with,  then  the  mortgage  shall  be 
foreclosed  and  the  property  sold  to  the  highest  bidder. 


36  Corporation  Finance 

This  is  a  legal  fiction.  Although  the  terms  are  the 
same  in  railway  mortgages  as  in  those  on  dwelling- 
houses,  the  commercial  facts  just  mentioned  forbid 
compliance  with  them.  In  the  great  majority  of  cases 
the  selling  of  a  railway  at  forced  sale,  even  to  another 
company,  is  out  of  the  question  except  as  the  result  of 
reorganization.  Partly  to  give  the  appearance  of  living 
up  to  the  terms  of  the  mortgage  and  partly  to  prevent 
those  terms  from  being  literally  carried  out,  the  courts 
appoint  receivers  for  railway  properties  in  bankruptcy 
or  about  to  become  so.  Out  of  this  contradiction 
between  the  too  strong  language  of  our  railway  mort- 
gages and  the  commercial  facts  which  control,  has 
arisen  the  American  custom  of  appointing  railway 
receivers,  a  custom  which  is  in  the  course  of  evolution, 
both  as  to  the  law  and  as  to  the  practice  under  that 
law.  The  English  **  debenture '  *  expresses  the  real 
situation  more  clearly  than  the  American  bond.  The 
former  by  its  language  limits  its  lien  to  the  earning 
capacity  of  the  company,  though  the  real  liens  are  the 
same  in  both  cases.  Probably  the  American  custom 
of  putting  into  the  railway  mortgage  terms  which  are 
stronger  than  the  commercial  facts  warrant  was  due  to 
the  feeling,  at  one  time  prevalent,  that  the  granting  by 
the  company  of  a  number  of  legal  rights  (such  as  fore- 
closure) supposed  to  be  absolute,  added  to  the  value  of 
the  security.  Something  of  this  feeling  remains  with 
us  yet,  for  in  the  United  States  the  debenture  bond, 
except  when  issued  by  companies  of  unusual  credit, 
like  the  New  York  Central,  is  not  classed  as  high  as 
bonds  drawn  in  the  American  fashion. 

The  principal  use  of  the  right  of  foreclosure  in  rail- 
way bonds  is  to  convey  title  to  a  reorganization  com^ 
mittee  in  case  of  insolvency.     The  courts  are  always 


Railway  Bonds  37 

careful  to  insist  upon  the  carrying  out  of  the  forms  and 
remedies  provided  for  in  the  mortgage,  when  cases  of 
this  sort  are  brought  before  them.  Yet  so  well  under- 
stood is  the  real  situation  that  the  same  courts  will  ask 
the  creditors  of  a  bankrupt  company  to  be  speedy  in 
coming  to  some  agreement  in  order  that  the  receivers 
may  be  discharged  ;  implying  that  the  receivers  are 
operating  the  property  in  order  to  keep  the  road  run- 
ning and  to  prevent  disintegration  of  the  system  as  a 
temporary  expedient,  until  some  readjustment  of  the 
obligations  can  be  made  ;  and  such  indeed  is  the  actual 
practice.  The  Richmond  and  West  Point  Terminal 
Railway  and  Warehouse  Company,  a  financing  corporat- 
ion formed  to  control  other  companies,  became  bankrupt 
in  1892.  An  elaborate  plan  of  reorganization  embrac- 
ing the  subsidiary  companies  was  promulgated  in  1894 
under  the  name  of  the  Southern  Railway  Company. 
To  bring  the  different  properties  under  one  company, 
foreclosure  proceedings  were  begun  and  carried  out 
against  the  Richmond  and  Danville  Railroad  Company,  • 
under  its  consolidated  mortgage  of  1886,  and  against 
the  East  Tennessee,  Virginia  and  Georgia  Railway  Com- 
pany, under  its  equipment  and  improvement  mortgage 
of  1888  and  its  general  mortgage  of  1890.  Those  and 
other  properties  embraced  under  the  West  Point  Com- 
pany were,  under  these  foreclosures,  bid  in  by  the 
Southern  Railway  Company,  subject  to  underlying 
liens.  Exchange  of  bonds  and  shares  of  these  fore- 
closed companies  for  those  of  the  new  company  were 
proceeded  with  according  to  the  plan  of  reorganization, 
the  suits  for  foreclosure  being  carried  out  without  oppo- 
sition to  transfer  the  title. 

But  since  railways  fill  so  large  a  part  in  our  modem 
industrial  life  and  since  we  can  safely  say  that  there 


38  Corporation  Finance 

must  be  carriers  of  traffic  so  long  as  civilization  en- 
dures, it  is  apparent  that  that  traffic  can  be  made  the 
security  for  the  borrowing  of  money  as  safely  and 
legitimately  as  can  a  dwelling-house  ;  provided  always 
that  those  rules  of  financiering  are  observed  which 
require  only  that  the  minimum  value  of  the  property 
be  represented  by  such  funded  debts.  The  investor, 
therefore,  need  not  fear  to  put  his  money  into  railway 
bonds  or  debentures  because  of  the  commercial  condi- 
tions under  which  railways  are  operated  ;  but  those 
commercial  conditions  require  that  he  should,  if  he 
seek  safety  for  his  investment,  consider  the  bearing  of 
these  facts  upon  the  particular  road  in  which  he  is 
interested.  If  the  earning  capacity  of  that  company 
becomes  for  any  reason  impaired,  the  strong  legal  lan- 
guage of  the  mortgage  will  not  save  the  holder  of  the 
company's  bonds  from  loss.  In  the  end  he  must  accept 
as  a  basis  for  revaluation  of  his  securities  the  earning 
power  of  the  company  as  a  carrier  of  traffic. 
^  When  money  is  loaned  upon  a  dwelling-house  the 
mortgage  is  made  to  cover  the  real  estate  as  security, 
the  bond  which  usually  accompanies  the  mortgage 
being  a  contract  uoder  which  the  mortgagor  pledges 
all  his  property  for  the  repayment  of  the  loan.  The 
terms  have  a  slightly  different  meaning,  however, 
when  applied  to  corporations.  The  mortgage  is  the 
indenture  issued  by  the  company  to  trustees  who  may 
be  trust  companies  or  individuals.  The  preference  for 
trust  companies  as  trustees  under  these  mortgages 
arises  from  the  fact  that  their  existence  is  continuous, 
that  they  have  all  the  machinery  for  properly  execut- 
ing large  transactions,  and  because  their  names  are 
known  to  all  investors. 

The  mortgage  made  to  trustees  contains  the  terma 


I 


Railway  Bonds  39 

under  which  the  money  is  borrowed.  Under  this  mort- 
gage and  governed  by  its  terms  the  Company  issues 
bonds  of  the  denomination  stated  in  the  instrument, 
usually  $1000,  which  bonds  may  be  registered  with  the 
interest  payable  by  check,  or  may  be  coupon  bonds 
accompanied  with  sheets  of  coupons  that  when  cut  off 
on  the  respective  interest  dates  are  payable  to  bearer  as 
drafts  upon  the  company  and  so  easily  collectible. 
The  one  form  of  bond  or  the  other  is  preferred  accord- 
ing as  the  holder  wishes  to  make  a  permanent  invest- 
ment secured  against  theft  or  destruction,  though  the 
sale  of  a  registered  bond  is  a  matter  requiring  some 
little  time  and  trouble — or  prefers  a  form  which,  in  the 
language  of  Wall  Street,  is  a  ''good  delivery*'  for 
instant  sale  at  any  time. 

The  railway  mortgage  usually  begins  by  giving  the 
name  of  the  company  with  the  particulars  of  its  incor- 
poration ;  then  follows  an  exhaustive  list  of  the  prop- 
erty to  be  mortgaged.  If  there  are  prior  liens  upon  the 
property  or  on  any  part  of  it,  these  exceptions  are 
stated.  Then  the  amount  for  which  the  mortgage  is 
to  be  issued  is  stated,  and  the  purposes  for  which  the 
money  is  to  be  used  should  be  given  in  detail.  Then 
may  be  stated  the  procedure  under  which  the  trustee  is 
allowed  to  certify  bonds  for  sale  to  the  public.  The 
object  of  appointing  a  trustee  is  to  see  that  the  legal 
formalities  embodied  in  the  mortgage  are  strictly  car- 
ried out,  and  that  there  is  no  over-issue.  The  mort- 
gage often  contains  a  provision  exempting  the  trustee 
from  all  liability  under  any  circumstances.  Sometimes 
the  bonds  are  to  be  certified  by  the  trustee  from  time  to 
time  merely  on  the  resolution  of  the  Board  of  Direct- 
ors ;  but  the  more  modem  mortgages  deny  this  power 
of  issue  until  certain  forms  are  observed.    For  instance, 


40  Corporation  Finance 

in  the  case  of  bonds  on  a  road  under  construction  it  is 
often  provided  that  no  new  bond  shall  be  issued  until 
a  certificate  is  filed  with  the  trustee,  signed  by  the 
president  and  chief  engineer,  certifying  that  the 
stated  number  of  miles  of  road  have  been  completed 
and  turned  over  to  the  operating  department. 

In  cases  where  there  are  existing  underlying  liens  it 
is  sometimes  provided  in  the  mortgage  that  these 
underlying  bonds  shall  be  paid  off  as  they  mature  and 
not  extended  ;'  this  is  done  in  order  to  insure  to  the 
issuing  bonds  a  first  lien  at  the  maturity  of  the  under- 
lying mortgages.  In  late  mortgages,  some  sections 
relating  to  reorganization  in  case  of  insolvency  have 
been  inserted.  The  sections  referring  to  the  foreclosure 
of  the  mortgage  are  usually  very  carefully  considered. 
A  common  arrangement  is  that  in  case  of  non-payment 
of  interest,  when  such  a  default  continues  for  six 
months,  at  the  request  of  a  certain  small  proportion  of 
the  bondholders,  the  trustee  may  begin  foreclosure  pro- 
ceedings or  enter  upon  the  possession  of  the  property  ; 
or  in  case  of  a  demand  by  a  considerable  percentage  of 
the  bondholders,  shall  do  so.  In  that  way  practical 
control  of  the  foreclosure  proceedings  is  given  to  a  cer- 
tain proportion  of  the  holders  of  the  bonds  outstanding. 
A  few  of  the  older  mortgages  give  this  power  of  control- 
ling foreclosures  to  a  small  proportion  (the  old  general 
mortgage  of  the  Philadelphia  and  Reading  granted  the 
privilege  to  ten  per  cent,  of  the  outstanding  bonds), 
but  the  later  mortgages  require  a  larger  percentage. 
Another  interesting  feature  in  modern  mortgages, 
inserted  because  of  certain  experience  in  that  direction, 
allows  the  trustees  under  certain  circumstances  to  with- 
draw the  proceedings  for  foreclosure,  if  such  have  been 
begun,  where  a  more  favorable  outcome  would  be  had 


Railway  Bonds  41 

by  compromise,  or  where  a  technical  default  should  not 
allow  the  company  to  pay  off  an  established  and  secure 
mortgage  not  yet  due,  for  the  sake  of  refunding  the 
loan,  in  that  compulsory  fashion,  at  a  lower  rate  of 
interest.  It  is  also  well  to  give  to  the  majority  of  the 
bonds  outstanding — say  three  fourths — the  power  to 
direct  a  trustee  to  buy  in  the  property  at  foreclosure  in 
accordance  with  any  plan  or  reorganization  which  may 
be  adopted,  and  also  under  certain  circumstances  to 
authorize  the  creation  of  new  mortgages  prior  to  the 
one  under  consideration.  These  latter  features  are  in 
the  mortgage  of  the  Southern  Railway  Company. 

Since  the  provisions  of  the  mortgage  govern  the  whole 
transaction,  and  since  a  mistake  here  may  have  disas- 
trous consequences,  it  is  the  usual  custom  to  employ 
good  corporation  lawyers,  so  that  the  terms  of  the 
mortgage  may  be  formulated  in  strict  accordance  with 
the  equities  of  the  case.  On  the  one  side  the  stock- 
holders, as  well  as  the  company  itself,  desire  that  the 
conditions  of  the  mortgage  shall  be  as  little  onerous  as 
possible;  on  the  other  hand,  the  lenders  wish  the  mort- 
gage drawn  so  as  to  give  them  the  best  security.  Just 
where  the  line  of  compromise  shall  fall  depends  to  a 
certain  extent  upon  the  reputation  of  the  company  and 
its  general  credit.  On  the  other  hand,  where  pro- 
visions of  the  mortgage  are  too  loosely  drawn,  they 
may  defeat  their  own  purpose  in  not  allowing  money 
to  be  borrowed  by  the  corporation  at  the  most  favor- 
able rates  and  under  the  most  favorable  conditions. 

Mortgages  are  divided  into  classes  and  called  by 
various  names  according  as  their  claim  upon  the  prop- 
erty is  direct  or  indirect.  Prior  lien  bonds  need  no 
particular  discussion.  Our  present  railway  systems 
have  been  formed  in  most  cases  out  of  a  number  of 


42  Corporation  Finance 

existing  roads.  In  a  great  many  instances  these  older 
and  smaller  companies  have  issued  bonds  which  are 
necessarily  the  first  mortgage  upon  their  respective 
portions.  These  senior  bonds,  as  they  are  sometimes 
called,  may  be  liens  upon  old  roads  which  are  now 
parts  of  the  new  main  line  and  worth  many  times  the 
original  mortgage.  Such  underlying  bonds,  having 
been  issued  years  ago,  often  bear  six  per  cent,  or  seven 
per  cent,  interest,  and  being  considered  thoroughly 
secure,  sell  on  the  exchanges  at  such  prices  as  yield 
the  investor  but  a  small  return.  Upon  the  system  as  a 
whole  there  may  be  a  first  mortgage,  so  called  because 
it  is  the  first  mortgage  of  the  consolidated  company, 
although  the  prior  lien  bonds  just  mentioned  of  course 
take  precedence  of  it.  After  the  first  mortgage  other 
bonds  may  come.  A  form  of  bond  which  was  at  one 
time  popular  but  afterwards  fell  into  partial  disrepute, 
is  the  income  or  preference  bond.  The  bond  is  so 
called  because  it  attempts  to  combine  the  lien  of  a  mort- 
gage with  contingency  of  interest.  The  mortgage  in 
due  form  declares  the  principal  to  be  a  claim  upon  the 
property,  but  follows  this  statement  with  another,  that 
no  interest  shall  be  paid  unless  it  has  been  earned.  In 
most  cases  the  question  whether  there  shall  be  any  net 
earnings  applicable  to  this  interest  in  any  given  year  is 
left  absolutely  to  the  discretion  of  the  Board  of  Direct- 
ors. A  fatal  objection  to  the  income  or  preference 
bond  is  that  it  is  an  attempt  to  combine  two  contra- 
dictory commercial  principles.  As  we  have  already 
seen,  the  lender  of  money  to  a  corporation  does  not 
wivSh  to  participate  either  in  the  profits  or  the  losses 
arising  from  the  success  or  failure  of  the  company,  but 
simply  intends  to  loan  his  money  on  what  he  thinks  is 
sufficient  security,  so  that  he  may  receive  the  interest 


Railway  Bonds  43 

on  the  same  and  the  principal  when  due.  To  the 
stockholders  who  manage  the  company  are  left  the 
profits  or  losses  over  and  above  this  charge  upon  the 
minimum  value  of  the  property,  whichever  these  may 
be.  It  will  be  noticed  that  security  for  both  interest 
and  principal  is  the  essence  of  the  creditor's  position,  \ 
while  contingency  depending  upon  success  is  the  \ 
essence  of  the  stockholder's  position.  We  might, 
therefore,  expect  that  a  so-called  bond  which  attempts 
to  combine  security  with  contingency  would  prove  dis- 
appointing to  all  concerned,  and  so  it  has  turned  out. 
In  some  cases  income  bonds  have  been  given  to  old 
security  holders  in  part  payment  for  sacrifices  which 
they  were  asked  to  make  because  of  former  insolvency. 
In  such  cases  it  would  have  been  better  had  these  old 
holders  accepted  their  changed  position  from  creditors 
to  partners  and  received  preferred  stock  for  their  de- 
ferred claims.  The  income  bonds  of  the  Atchison, 
Topeka  and  Santa  Fe,  issued  after  the  reorganization  of 
1889,  and  the  preference  bonds  of  the  Philadelphia  and 
Reading,  issued  after  the  reorganization  of  1886,  are 
instances  of  such  bonds.  A  practical  objection  often 
raised  to  income  bonds  by  British  and  German  holders 
of  such  bonds,  is  that  the  Board  of  Directors  represent- 
ing the  shareholders  may  in  years  of  good  earnings  put 
into  the  property  the  surplus  revenues  which  might 
have  gone  toward  paying  interest  on  the  income  bonds, 
and  continue  such  a  policy  until  such  time  as  the  earn- 
ings of  the  company  justify  paying  interest  to  the 
income  holders  and  at  the  same  time  a  dividend  on 
stock.  Against  such  appropriation  of  the  earnings, 
when  equitably  due  to  them,  the  income  holders  have 
usually  no  remedy.  Sometimes  the  power  of  voting 
has  been  given  to  such  bonds  in  order  to  guard  against 


44  Corporation  Finance 

such  a  possible  abuse  ;  but  preferred  stock  is  a  better 
thing  to  issue  and  to  bold  under  these  circumstances 
than  the  miscalled  income  bond. 

In  our  corporation  history  there  have  been  instances 
of  preference  bonds,  like  those  of  the  Philadelphia  and 
Reading,  with  the  definition  of  net  earnings  applicable 
to  their  payment  drawn  in  the  mortgage  of  1888  in 
such  severe  terms  that  there  seemed  no  loophole  of 
escape.  Nevertheless  charges  have  in  such  cases  been 
ingeniously  put  ahead  of  such  bonds.  It  may  happen, 
too,  that  the  very  severity  of  the  language  which  is  in- 
tended to  compel  the  payment  to  the  preferred  holder 
of  all  earnings  over  and  above  certain  specified  and 
fixed  charges,  by  defeating  other  borrowings  or  by 
depriving  the  company  of  improvement  moneys,  may 
so  embarrass  the  managers  of  the  company  as  to  cause 
the  preference  bonds  themselves  to  fall  in  value. 

Another  form  of  corporation  borrowing  of  which  we 
have  seen  instances  in  late  years,  is  that  of  collateral 
bonds  or  trust  notes.  Collateral  bonds  are  obligations 
issued  by  a  company  with  a  lien  upon  the  real  estate 
junior  to  that  of  other  mortgages.  To  give  these  col- 
lateral bonds  value  in  the  eyes  of  investors  they  are 
made  a  first  lien  upon  various  bonds  and  stocks,  usu- 
ally of  auxiliary  companies,  which  are  taken  from  the 
treasury  of  the  system  and  deposited  with  some  trust 
company  as  trustee  under  the  terms  of  the  collateral 
mortgage.  As  the  name  implies,  such  a  mortgage  is 
really  a  borrowing  upon  the  collateral  owned  by  the 
company,  and  differs  from  the  borrowing  of  money  from 
the  banks  through  the  hypothecation  of  the  securities 
in  the  company's  treasury,  only  by  arranging  for  a  loan 
for  a  term  of  years  and  at  a  fixed  rate  under  certain 
specified  conditions 


I 


t  Railway  Bonds  45 

A  large  system  which  has  been  formed  by  the  con- 
solidation from  time  to  time  with  it  of  various  other  and 
smaller  corporations  usually  finds  that  it  has  collected 
in  its  treasury  a  considerable  number  of  bonds  or 
shares  which  represent  to  it  its  investments  for  control. 
These  bonds  or  shares  are  those  of  railroad  companies 
whose  corporate  existence  may  still  be  kept  up,  but 
which  form  nevertheless  an  integral  part  of  the  present 
system  ;  or  they  may  be  the  bonds  or  shares  of  ter- 
minal companies,  or  warehouse  or  elevator  companies, 
or  of  some  water  transportation  company  which  pro- 
vides by  river  or  lake  an  important  connection  with 
the  present  company  ;  or,  of  companies  which  furnish 
much  traffic  to  the  railroads,  and  whose  securities 
were  bought  in  order  that  that  traffic  may  be  held 
for  the  system  beyond  a  doubt.  In  all  these  cases 
it  is  assumed  that  the  continuance  of  the  control  of  the 
parent  company  over  the  various  enterprises  whose 
bonds  and  shares  it  holds  is  necessary  to  the  preserva- 
tion of  the  system  and  to  the  securing  to  the  system  of 
the  traffic  represented.  To  pledge  these  various  shares 
and  bonds  for  a  new  loan  is  regarded  as  legitimate 
financiering  because  it  grants  to  the  holders  of  the  col- 
lateral bonds  a  claim  upon  the  assets  of  the  company,  a 
claim  which  often  in  effect,  though  not  in  name,  is 
equal  to  that  of  regular  mortgage  bonds. 

An  illustration  of  such  mortgages  by  a  strong  com- 
pany is  that  of  the  four  per  cent,  extension  bonds  of  the 
Chicago  and  Northwestern  Railway  Company,  issued 
in  1886,  upon  the  bonds  of  the  branch  road,  the  Fre- 
mont, Elkhorn,  and  Missouri  Valley,  deposited  with  the 
trustee  as  collateral.  In  like  manner  the  Illinois  Cen- 
tral Railroad  Company  in  1888  issued  collateral  bonds 
based  upon  the  deposit  with  the  trustee  of  various 


46  Corporation  Finance 

bonds  of  subsidiary  roads  important  to  the  system. 
The  uncertainty  of  the  value  of  a  claim  upon  collateral 
in  cases  of  insolvency  is  illustrated  by  the  history  of 
the  collateral  trust  bonds  of  the  Oregon  Short  Line  and 
Utah  Northern  Company.  This  company,  under  the 
control  of  the  Union  Pacific,  purchased  more  than  half 
the  stock  of  the  Oregon  Railway  and  Navigation  Com- 
pany (a  connecting  road),  and,  depositing  the  same 
with  the  trustee,  issued  thereon  its  collateral  trust 
bonds.  Pending  the  reorganization  of  the  Union 
Pacific  and  because  of  a  decline  in  the  earnings  of  the 
Oregon  Railway  and  Navigation  Company,  the  value  of 
these  collateral  trust  bonds  became  but  nominal.  In 
1883  the  Wabash,  St.  Louis,  and  Pacific  issued  $6,000,000 
of  collateral  trust  bonds  bearing  six  per  cent,  interest 
and  sold  them  to  the  public  at  90.  Under  the  reor- 
ganization of  this  company  into  the  Wabash  Railroad 
Company  (dating  from  July,  1889)  these  collateral  trust 
bonds  were  exchanged  into  debenture  ' '  B  ' '  bonds  of 
the  new  company,  the  latter  being  quoted  at  less  than 
one  third  of  the  price  at  which  the  collateral  trust 
bonds  were  originally  issued  and  sold. 

The  difiiculty  which  experience  has  found  with  col- 
lateral bonds  lies  in  the  fluctuating  value  of  the  securi- 
ties pledged  under  them.  The  collateral  bond  held  by 
the  public  is  a  mortgage  upon  certain  other  mortgages, 
and  if  foreclosed  by  reason  of  insolvency  the  purchasers 
j  legally  come  into  possession,  not  of  the  real  estate  of 
[the  company,  but  of  certain  other  bonds,  which  in  turn 
may  have  to  be  foreclosed  separately,  necessitating  a 
large  number  of  distinct  actions.  The  loss  is  the  same 
whether  these  separate  transactions  are  actually  carried 
out  or  an  equivalent  reduction  made  in  the  quoted 
values  of  the  bonds.     Not  only  is  the  expense  of  the 


Railway  Bonds  47 

transaction  and  the  ultimate  outcome  made  doubtful  by 
these  facts,  but  in  securing  the  absolute  property  delays 
which  may  occur  under  these  circumstances  may  cause 
further  losses  ;  for  it  is  plain  that  the  value  of  the  sub- 
sidiary properties  whose  bonds  and  shares  are  pledged 
as  collateral  may  depend,  in  cases  where  the  mortgag- 
ing company  becomes  bankrupt,  largely  upon  the 
quickness  with  which  they  may  be  seized  upon  and 
handled  with  vigor  by  their  new  owners.  In  a  devel- 
oping country  new  discoveries  in  mining  may  be  made, 
or  new  centres  for  trade  distribution  or  manufacturing 
may  be  formed,  which  may  change  the  value  to  the 
system  of  a  branch  line  or  auxiliary  company  so  materi- 
ally and  so  rapidly,  that  holders  of  a  funded  obligation 
resting  for  security  upon  these  subsidiary  properties 
may  find  their  real  security  slipping  away  from  them 
while  they  are  yet  helpless.  For  these  reasons  a  collat- 
eral bond  usually  ranks  in  quotations  below  that  of 
other  mortgages  of  the  same  company  covering  specific 
portions  of  its  property. 

But  while  these  remarks  are  true  in  many  cases  there 
are  instances,  like  those  of  the  Chicago  and  Northwest- 
ern and  Illinois  Central,  to  which  they  do  not  practi- 
cally apply.  There  are  railways  which  have  been  in 
operation  for  many  years  and  whose  trafl&c  not  only  as 
to  volume  but  as  to  source  has  become  well  established. 
Fluctuations  in  the  value  of  the  properties  directly 
owned  by  such  companies  are  so  little  likely  to  occur 
that  collateral  bonds  issued  upon  the  stocks  and  bonds 
of  such  subsidiary  properties  are  a  comparatively  safe 
investment.  There  is  no  hard  and  fast  rule  for  judging 
of  the  lien  in  these  cases.  Each  company  and  each 
collateral  mortgage  must  be  valued  by  the  merits  in 
each   particular   case.      The  general  reputation  and 


48  Corporation  Finance 

credit  of  the  mortgaging  company  should  also  be  taken 
into  consideration. 

The  objections  raised  to  collateral  bonds  before 
spoken  of  have  led  to  variations  in  the  form  intended 
to  meet  these  difficulties.  Such  a  variation  is  that  of 
collateral  trust  notes.  Like  collateral  bonds  these  notes 
are  an  obligation  of  the  issuing  company  and  are  made 
a  first  lien  upon  certain  shares  and  bonds  of  properties 
important  to  the  system,  which  are  given  to  some  trust 
company  to  be  held  as  collateral  for  the  notes.  With 
this  difference,  however,  that  the  mortgage  gives  the 
control  of  the  hypothecated  bonds  and  shares  to  a  par- 
ticular trust  company  or  to  a  committee  of  financiers, 
who  have  the  power  to  dispose  of  these  hypothecated 
bonds  and  shares  under  circumstances  which  are  care- 
fully stated  in  the  mortgage.  Sometimes  authority  is 
given  to  this  committee  to  sell  these  hypothecated 
securities  at  certain  stipulated  prices  or  at  their  discre- 
tion, the  proceeds  of  the  sale  being  used  to  redeem  the 
collateral  notes  ;  or  else  the  committee  are  empowered 
to  make  such  sales  either  of  all  or  of  part  of  the  securi- 
ties as  they  may  deem  best,  in  case  of  a  forfeiture  of 
interest  payments  by  the  obligating  company.  These 
provisions,  with  others  of  the  same  tenor,  are  inserted 
in  the  collateral  trust  mortgage  in  order  to  do  away 
with  the  objections  of  investors  and  by  making  the 
transaction  more  nearly  like  the  ordinary  borrowings 
of  money  at  the  banks,  to  command  a  higher  price  for 
these  notes  than  would  otherwise  be  obtainable.  Exam- 
ples may  be  found  in  the  issues  of  collateral  trust  notes 
by  the  Union  Pacific  and  Northern  Pacific  Companies 
in  1891  and  1893. 

Railway  systems  which  have  attained  their  present 
magnitude  either  through  the  consolidation  of  parts  of 


Railway  Bonds  49 

their  road  at  different  times  or  through  the  amalgama- 
tion at  one  time  of  a  number  of  smaller  companies, 
often  find  themselves  obliged  to  provide  new  capital  in 
order  to  arrange  for  improvements  necessary  for  hand- 
ling a  larger  amount  of  business,  improvements  which 
are  required  in  order  to  introduce  the  very  economies  in 
operating  for  which  the  combination  may  have  been 
formed.  In  a  developing  country  like  the  United 
States  the  demand  for  railway  capital,  except  in  periods 
of  depression,  is  continuous.  As  traffic  grows  so  must 
facilities  increase.  And  since  it  has  heretofore  been 
our  experience  that  an  increase  in  the  number  of  pas- 
sengers and  tons  of  freight  is  accompanied  by  a  de- 
crease in  the  amount  received  per  passenger  or  per  ton, 
an  American  road  should  be  considered  well  managed 
if  the  net  earnings,  legitimately  arrived  at,  increase  a 
little  faster  than  the  fixed  charges.  Such  a  result,  if 
fairly  obtained,  proves  that  the  additional  capital  spent 
upon  the  property  from  year  to  year  has  been  product- 
ive. Acknowledging  that  systems  require  the  expend- 
iture of  money,  it  often  becomes  a  problem  upon  what 
special  security  this  money  should  be  raised.  One 
method  is  that  of  issuing  ''blanket''  mortgages,  as 
they  are  called,  a  Wall  Street  term  which  means  merely 
that  the  system  which  already  has  prior  mortgages 
upon  different  parts  of  it,  now  issues  bonds  which  cover 
the  system  as  a  whole,  subject,  of  course,  to  the  under- 
lying encumbrances  upon  the  property. 

In  the  minds  of  financial  men  some  of  these  blanket 
mortgages  do  not  hold  a  first-class  position  ;  the  feeling 
against  them  may  be  summed  up  thus  :  blanket  bonds 
are  not  first  mortgages — a  fact  which  everyone  must 
admit.  Yet  if  it  is  true  that  systems  must  grow,  just 
as  parts  of  the  same  system  increased  while  inde- 


50  Corporation  Finance 

pendent,  there  is  much  to  be  said  in  justification  of 
obtaining  capital  by  bonding  the  system  as  a  whole. 
The  majority  of  the  things  needed  by  the  system  are 
such  as  are  chargeable  upon  the  separate  parts  only 
proportionately.  Equipment  which  is  bought  for  the 
benefit  of  the  system  should  not  be  paid  for  by  the  fur- 
ther issue  of  divisional  bonds,  even  where  such  addi- 
tional issues  are  provided  for  in  the  divisional  mortgage. 
So,  too,  bonds  sold  for  the  acquisition  of  freight  yards 
are  intended  to  facilitate  the  handling  of  traffic  over  the 
whole  system.  In  the  approaching  days  when  the  use 
of  air-brakes  for  freight  trains  and  of  one  pattern  of 
freight-car  coupler  will  increase  the  number  of  trains 
which  may  be  moved  rapidly  and  safely  over  any  par- 
ticular piece  of  road,  the  capacity  of  the  terminals  rather 
than  that  of  the  track  will  even  more  than  at  present 
prove  the  standard  by  which  the  limit  to  the  volume 
of  traffic  will  be  measured.  It  would  be  unjust  under 
these  present  or  supposed  future  circumstances  to 
charge  the  cost  of  such  terminals  to  that  part  of  the 
whole  system  upon  which  they  may  happen  to  be 
located.  There  is  no  way  of  meeting  these  demands 
so  equitably  as  by  the  issue  of  system  bonds  for  system 
improvements.  Blanket  mortgages  have  been  issued  by 
the  Chicago,  Milwaukee,  and  St.  Paul  and  the  lyouis- 
ville,  and  Nashville  Railway  Companies,  among  others. 
If  these  blanket  mortgages  are  carefully  drawn  with 
provisions  compelling  the  retirement  of  the  prior  liens 
as  such  mature,  they  will  in  time  become  first  mort- 
gages themselves.  Some  modern  blanket  mortgages 
also  contain  sections  limiting  the  amount  of  bonds 
which  may  be  issued  for  improvement  in  any  one  year, 
the  intention  being  to  prevent  the  forcing  upon  the 
market  of  such  an  issue  of  bonds  as  to  cause  a  decline 


Railway  Bonds  5 1 

in  price,  and  also  to  check  a  yearly  issue  in  excess 
of  reasonable  requirements.  An  example  of  such  a 
guarded  mortgage  covering  an  issue  of  blanket  or  sys- 
tem bonds  is  that  of  the  Cleveland,  Cincinnati,  Chi- 
cago, and  St.  I^ouis  general  mortgage  of  1893. 

If  corporations  become  insolvent  it  is  expected  that 
such  blanket  or  general  bonds  will  be  the  first  to  be 
seriously  affected.  The  Wabash,  St.  Louis,  and  Pacific 
Company  in  1880  issued  and  sold  $16,000,000  of  its 
six  per  cent.  *' general  *'  or  system  bonds  at  95.  Be- 
coming bankrupt,  a  new  corporation,  the  Wabash  Rail- 
road Company,  was  formed  in  1889.  The  general 
bonds  of  the  old  company  were  converted  into  deben- 
ture *  *  B  "  bonds  of  the  new  company,  these  being 
quoted  at  less  than  one  third  of  the  price  at  which  the 
generals  were  originally  sold. 

There  is  no  doubt  that  blanket  mortgages  may  lend 
themselves  to  over-colored  notions  of  future  possible 
traffic  sometimes  held  by  optimistic  managers.  The 
ease  with  which  such  bonds  may  be  issued  to  the  large 
amounts  for  which  the  mortgages  are  made  sometimes 
proves  too  tempting  to  railway  officers  who,  through 
good  motives  or  bad,  venture  upon  extravagant  calcu- 
lations of  the  growth  in  business  for  the  future.  In 
such  cases  blanket  bonds  are  not  regarded  much  more 
highly  than  would  be  the  same  amount  of  preferred 
stock.  While  this,  however,  is  a  danger,  it  is  not  a 
good  argument  against  system  bonds  when  legitimately 
issued.  Blanket  bonds  should  be  judged,  therefore, 
by  that  principle  in  general  debt  financiering  which 
reqtiires  the  amount  of  borrowed  money  to  be  well 
within  the  minimum  value  of  the  property.  When  this 
requirement  is  kept  in  view,  and  when  the  company 
has  been  operating  its  lines  of  railway  long  enough  to 


52  Corporation  Finance 

allow  a  fair  estimate  as  to  the  stability  of  the  traffic, 
the  issue  of  blanket  or  system  bonds  is  proper  and  safe. 
One  form  of  railway  mortgages  differing  somewhat 
from  those  which  have  just  been  considered,  is  that  of 
terminal  bonds.  Mortgages  upon  terminal  properties 
which  are  indispensable  to  the  successful  operation  of 
railways  are  generally  well  regarded  by  investors. 
Proper  terminals  are  more  and  more  essential  to  our 
railways  as  the  commercial  development  of  the  country 
proceeds.  Passenger  stations  in  important  cities,  with 
the  land  necessary  for  approaching  tracks,  are  neces- 
sary if  a  company  is  to  continue  in  business  and  not  to 
yield  its  traffic  to  some  rival ;  and  mortgages  upon  such 
properties  are  well  thought  of.  Mortgages  upon  some 
railway  terminals  at  Chicago  and  New  York  are  exam- 
ples. There  are  other  terminal  bonds,  however,  which 
cover  cases  not  precisely  similar  to  the  one  just  men- 
tioned. Terminal  properties  which  are  used  or  may  be 
used  by  two,  three,  or  more  railroads  sometimes  depend 
for  their  immediate  value  upon  the  question  whether 
their  facilities  are,  or  in  the  near  future  can  be,  fully 
utilized  ;  or  whether  one  or  more  of  the  occupying 
companies  may  not  transfer  their  favors  to  some  other 
terminal  property  more  accessible  to  their  lines.  These 
inquiries  embrace  also  another  set  of  facts ;  whether 
the  properties  covered  by  the  mortgage  under  consid- 
eration are  the  best  that  can  be  had  and  whether  they 
are  therefore  from  that  point  of  view  also  sure  of  con- 
tinued occupancy.  The  case  of  the  Chicago  and  North- 
ern Pacific  Company  is  an  illustration.  This  company 
acquired  lands,  tracks,  and  other  terminal  properties  in 
the  city  of  Chicago,  and  in  1890  authorized  an  issue  of 
$30,000,000  five  per  cent,  bonds.  It  was  admitted  that 
the  properties  covered  by  the  mortgage  were  of  great 


Railway  Bonds  53 

value  of  themselves,  but  because  of  lack  of  tenants  fully 
to  utilize  their  facilities,  on  the  appointment  of  receivers 
for  the  Northern  Pacific  and  Wisconsin  Central  Com- 
panies in  1893  (companies  which  had  practically  guar- 
anteed bond  interest),  the  Chicago  and  Northern  Pacific 
was  likewise  placed  in  the  hands  of  receivers,  its  bonds 
falling  in  price  to  one  half  their  former  quotations. 

In  other  cases  railway  companies  have  themselves 
issued  terminal  bonds  which  they  make  a  first  lien  on 
certain  specific  terminal  properties  of  their  own.  In 
such  instances  the  value  of  the  grounds  and  buildings 
in  cities  must  be  judged  according  to  the  hints  already 
given.  If  such  bonds,  however,  cover  terminals  in 
towns  or  villages  remote  from  cities  or  away  from 
places  which  from  the  trafiic  point  of  view  may  be 
called  strategic,  the  question  may  arise  whether  the 
land  thus  set  apart  for  country  terminals  has  any 
special  value  for  railroad  purposes.  If  the  company 
could  easily  put  down  elsewhere  tracks  and  buildings 
suitable  for  their  purpose,  then  their  so-called  terminal 
bonds  are  dependent  for  their  value  not  so  much  on  the 
property  mortgaged  as  upon  the  general  success  of  the 
company  as  a  carrier  of  traffic. 

Some  of  the  older  of  our  railway  mortgages  provide 
for  a  sinking  fund.  The  sections  relating  to  such  funds 
usually  provide  that  a  certain  sum  shall  be  set  apart 
annually  and  paid  to  the  mortgage  trustees.  These 
sums  are  to  be  invested  in  the  company's  bonds  of  the 
issue  to  be  thus  retired,  either  by  purchase  in  the  open 
market  or  more  commonly  at  a  price  fixed  in  the  mort- 
gage, the  particular  bonds  required  being  drawn  by  lot 
and  the  result  advertised  in  the  daily  papers.  The 
bonds  thus  chosen  cease  drawing  public  interest.  It  is 
usually  also  provided  in  such  cases  that  the  bonds  pur- 


54  Corporation  Finance 

chased  by  lot  shall  not  be  cancelled  but  remain  alive 
(that  is,  remain  in  all  their  original  force  against  the 
company)  in  the  hands  of  the  mortgage  trustee,  the 
interest  on  them  being  added  to  the  sinking  fund  and 
used  in  the  purchase  of  further  outstanding  bonds. 
By  this  method  it  is  not  difficult  to  calculate  the  exact 
annual  payments  by  the  company  which  will  be  neces- 
sary in  order  that  the  mortgage  trustee  at  the  maturity 
of  the  mortgage  may  have  on  hand  the  amount  of 
money  required  to  pay  all  interest  and  principal  and 
thus  cancel  the  whole  issue. 

It  is  sometimes  provided  that  the  money  contributed 
by  the  company  to  form  a  sinking  fund  may  be  used  to 
purchase  other  bonds  of  the  same  system  in  case  the 
bonds  in  question  cannot  be  had  at  a  named  price  ;  or 
perhaps  the  whole  matter  is  left  to  the  discretion  of  the 
trustee  or  of  the  company's  directors.  It  usually  hap- 
pens that  the  quotations  of  such  sinking-fund  bonds  are 
higher  than  the  purchase  price  named  in  the  sinking- 
fund  sections  of  the  mortgage,  and  hence  the  invest- 
ment of  the  fund  in  other  securities  is  necessary. 

The  course  followed  in  such  cases  is  to  buy  such 
other  bonds,  perhaps  of  subsidiary  roads,  as  will  indeed 
make  up  the  par  value  required  at  maturity,  but  whose 
value  depends  upon  the  fact  that  they  are  obligations 
of  the  selfsame  system.  Such  bonds — or  indeed  any 
bonds  other  than  the  issues  originally  intended  to  be 
extinguished  by  the  sinking  fund — could  not  be  sold  to 
the  public  without  increasing  the  interest  charges  pay- 
able to  the  public  by  the  amount  of  the  interest  on  the 
old  bonds.  In  this  way  the  owners  of  the  old  bonds 
indeed  receive  their  principal  and  interest,  but  the  fixed 
charges  of  the  system  are  not  in  any  wise  reduced  by 
the  transaction.     Sometimes  it  is  thought  desirable  for 


Railway  Bonds  55 

the  company  to  take  over  into  the  treasury  all  these 
securities  held  in  the  funds,  the  maturing  issues  being 
meanwhile  met  by  sales  of  other  bonds  of  the  same 
company  which  bear  a  lower  rate  of  interest  or  are  part 
of  a  larger  mortgage  and  already  sure  of  a  market.  In 
such  cases  the  labor  of  keeping  up  the  sinking  fund  is 
thrown  away,  because  usually  the  exchange  of  the  new 
bond  for  the  old  could  have  been  easily  accomplished 
without  that  machinery. 

When  railway  companies  are  in  good  credit,  or  when 
the  mortgage  containing  sinking-fund  clauses  covers 
property  conceded  to  be  worth  more  than  the  bonds, 
the  establishment  of  such  funds  is  a  financial  mistake. 
If  the  bonds  are  to  be  compulsorily  retired  so  many 
each  year  by  lot  at  say  no  per  cent,  of  their  par  value, 
that  fact  immediately  decreases  their  value  as  invest- 
ments. No  investor  likes  to  buy  bonds  which,  how- 
ever good  or  whatever  the  premium  he  may  have  paid 
for  them,  he  may  have  to  give  up  a  short  time  after 
purchasing.  If  a  bond  is  really  good,  the  longer  the 
time  it  has  to  run  the  better  the  bond-buyers  like  it. 
Another  practical  objection  is  that  no  one  wishes  to  be 
on  the  lookout  for  advertisements  which  he  may  or 
may  not  chance  to  see,  but  which  are  legal  notices 
binding  on  the  bondholder  that  interest  on  the 
bonds  named  by  their  numbers  ceases  on  a  certain 
date. 

On  the  other  hand,  the  companies  would  rightly 
object  to  a  sinking-fund  system  which  should  require 
them  to  contribute  certain  sums  yearly  to  be  used  in 
buying  that  particular  issue  of  bonds  in  the  open  mar- 
ket. Such  a  provision  would  soon  create  an  artificial 
scarcity  in  those  bonds  so  that  the  price  quotations 
would  be  above  the  normal.     To  purchase  at  a  high 


56  Corporation  Finance 

premium  bonds  which  at  maturity  the  company  could 
pay  at  par  would  be  poor  financiering,  and  a  use  of  the 
current  revenues  of  the  company  to  which  the  share- 
holders could  properly  object.  The  form  of  sinking 
fund  which  allows  of  the  investment  of  the  funds  in 
securities  other  than  those  intended  to  be  retired,  is  of 
little  practical  value  to  the  bondholders  in  question. 
Their  mortgage  is  upon  a  certain  piece  of  property,  and 
that  is  still  their  main  hope.  It  usually  happens  that 
the  securities  purchased  by  such  a  fund  are  those  of  the 
same  system,  and  thus  at  maturity  it  is  often  found  that 
to  pay  off  one  obligation  there  is  nothing  in  the  fund  but 
another  obligation  of  the  same  company  ;  and  if  the 
first  is  not  itself  good,  the  other  is  not  likely  to  be 
worth  much.  Investments  of  sinking  funds  in  bonds 
of  other  enterprises  are  not  favored  for  obvious  reasons, 
while  purchases  of  such  undoubted  securities  as  govern- 
ment bonds  at  high  premiums  would  cost  the  company 
and  the  bond-  and  shareholders  more  than  the  accruing 
benefits.  For  these  reasons,  sinking-fund  requirements 
have  been  left  out  of  most  of  our  modern  railway  mort- 
gages. As  to  companies  in  poor  credit,  whose  bonds 
rule  very  low  in  price,  there  is  not  much  to  be  said. 
Corporation  financiering  requires  that  debts  shall  be 
only  of  such  a  proportion  to  the  real  value  as  will  bring 
the  highest  returns  to  the  company  with  the  lowest  rate 
of  interest.  Sinking  funds  do  not  need  discussion 
where  different  conditions  prevail.  As  such  funds  can 
be  accumulated  from  but  one  source — the  revenues  of 
the  company,  and  as  under  our  present  supposition, 
those  reserves  are  not  enough  to  sustain  the  bond 
credit,  it  is  practically  useless  to  rely  upon  them  for  the 
formation  of  any  such  thing  as  a  sinking  fund.  Com- 
panies in  distress  will  always  use  current  revenues  to 


Railway  Bonds  57 

pay  pressing  needs  regardless  of  sinking-fund  clauses 
in  their  mortgages. 

Since  under  practical  conditions  sinking  funds  in 
the  mortgages  of  railways  having  good  credit  are  not 
favored,  we  may  next  inquire  as  to  the  public  aspect  of 
the  matter.  In  national  finance  it  is  now  understood 
that  sinking  funds  for  the  payment  of  government 
bonds  can  be  established  only  from  governmental  rev- 
enues ;  in  short,  from  taxes.  If,  therefore,  it  be  the 
opinion  that  the  government  should  not  remain  always 
in  debt,  but  arrange  to  pay  off  its  borrowings  by  de- 
grees, the  funds  must  be  supplied  from  taxes.  The 
government  is  not  in  business  and  has  no  business  rev- 
enues. But  corporations  which,  so  far  as  we  now  see, 
must  continue  to  earn  money  through  their  services  to 
the  public  indefinitely,  occupy  a  different  place.  The 
rules  covering  public  debt  financiering  do  not  now 
apply.  Rather  do  we  see  the  opposite,  where  borrow- 
ing is  not  only  a  necessity,  but  often  the  only  road  to 
success.  The  revenues  of  such  corporations  do  not 
come  from  taxes,  but  from  moneys  given  to  them  in 
return  for  services  rendered  in  a  business  way  to  those 
concerned.  Such  services  must  in  some  form  be  con- 
tinuous, and  the  benefits  paid  for  continuously  on  a 
business  basis.  Moreover,  through  competition  or  in 
other  ways,  the  profits  of  such  companies  tend  toward 
smaller  margins,  these  being  usually  only  enough  to 
pay  a  fair  return  to  the  capital  invested.  Since  the 
only  way  to  pay  off  debts  is  from  revenue,  it  follows 
that  the  retirement  of  bonds  at  maturity  by  cash  pay- 
ment (except,  of  course,  through  the  sale  of  other 
bonds)  could  be  effected  only  by  increasing  the  revenues 
through  advancement  of  the  prices  charged  to  passen- 
gers and  shippers,  or  by  the  shareholders  (or  perhaps 


58  Corporation  Finance 

the  bondholders  themselves)  foregoing  their  returns  for 
years.  As  a  practical  matter  either  way  is  unadvisable 
or  impossible.  Unlike  taxes,  rates  or  prices  could  not 
be  advanced  so  largely  as  to  pay  off  bonded  debts. 
Railway  charges,  for  example,  could  not  be  increased 
to  that  extent  in  the  face  of  an  adverse  public  opinion. 
On  the  other  hand,  to  stop  dividends  for  such  a  pur- 
chase would  prove  equally  unpopular,  and  would  also 
result  in  a  decay  of  public  progress  in  our  industries  ; 
for  no  one  would  undertake  a  new  enterprise  if  he  were 
not  permitted  to  reap  the  annual  fruits  of  his  ability 
and  labor. 

For  these  reasons  the  payment  of  corporation  debts 
,from  corporation  revenues  is,  generally  speaking,  im- 
possible in  practice.  Hence  it  is  assumed — by  large 
railway  systems,  for  illustration — that  when  an  existing 
mortgage  matures  the  company  will  be  able  to  borrow 
new  money  to  pay  off  the  old,  and  perhaps  at  a  lower 
rate  of  interest.  Sinking  funds  for  such  a  purpose  are 
unnecessary,  though,  as  a  matter  of  formal  obligation, 
they  may  be  kept  up  by  companies  in  good  credit,  like 
the  Chicago,  Burlington,  and  Quincy  or  Chicago  and 
Northwestern.  But  reference  has  been  made  to  corpo- 
rations which  it  is  assumed  will  go  on  doing  a  stable 
business  indefinitely.  Other  companies  may  be  subject 
to  extreme  fluctuations  in  profits,  or,  like  mining  cor- 
porations, may  have  a  certain  number  of  years  to  run 
when  their  business  opportunities  will  be  exhausted. 
In  such  cases  sinking  funds  fulfil  a  proper  purpose — 
that  of  guarding  the  interests  of  the  mortgagees,  and 
should  be  insisted  upon  ;  such  funds  may  be  established 
either  by  way  of  deposit  with  trustees  of  mone3^s  to 
purchase  bonds  or  be  held  in  trust,  or  by  writing  off  the 
values  of  the  plant  before  paying  dividends  and  holding 


Railway  Bonds  59 

such  moneys  in  a  sort  of  depreciation  account,  or  by  a 
combination  of  both  methods.  There  is  no  real  con- 
fusion between  indefinite  and  short-lived  companies,  for 
by  a  commercial  law  the  short-lived  corporation  may 
retain  a  rate  of  profit  on  its  transactions  high  enough, 
if  well  managed,  for  all  sinking-fund  purposes,  and 
higher  than  anything  which  the  stable  corporation  may 
hope  to  gain.  A  business  which  bears  no  evidence  of 
stability  and  endurance,  or  whose  life,  if  it  is  to  be 
short,  cannot  be  calculated  and  provided  for,  should 
not  become  incorporated.  The  partnership  form  is  best 
adapted  to  enterprises  which  are  largely  speculative  in 
character. 

In  order  to  draw  capital  from  all  sources,  corporation 
mortgages  are  made  to  trustees  who  certify  to  certain 
bonds  of  small  denominations.  In  this  way  the  bor- 
rowings of  corporations,  amounting  in  some  cases  to 
more  than  a  hundred  million  dollars  at  a  time,  are 
divided  into  small  sums  within  the  reach  of  the  humble 
investor.  Of  late  years  the  trust  companies  in  the 
Eastern  cities  have  been  selected  as  trustees  instead  of 
individuals  whenever  the  law  of  the  State  where  the 
property  was  situated  allowed  of  such  selection.  Trust 
companies  have  manifold  advantages  over  individuals 
in  such  a  relationship  ;  they  do  not  die  ;  the  large 
amount  of  financial  business  which  they  daily  transact 
provides  them  with  the  machinery  for  such  purposes  ; 
while  their  well-known  names  stand  as  evidence  to  the 
purchasing  public  that  at  least  the  necessary  formal- 
ities have  been  complied  with.  Beyond  that  responsi- 
bility the  trustees  of  corporation  mortgages  usually 
assume  none. 

In  recent  years  the  trust  companies  have  shown  a 
tendency,  when  acting  as  mortgage  trustees,  to  recog- 


6o  Corporation  Finance 

VlVl^  a  greater  moral  responsibility  than  they  at  first 
were  willing  to  bear.  Trust  companies  did  not,  of 
course,  intend  to  appear  as  in  any  way  guaranteeing 
the  bonds  to  which  they  certified,  though  that  seems 
often  to  have  been  the  erroneous  opinion  of  the  un- 
thinking ;  but  trustees  now  acknowledge  themselves 
bound  within  the  limits  of  the  mortgage  to  use  their 
influence  to  protect  the  interests  of  the  bondholders. 
A  trust  company  which  should  now  allow  the  issue  of 
unsecured  bonds  because  of  some  glaring  defect  in  the 
language  of  the  mortgage,  would  no  longer  be  morally 
excused  by  financial  opinion,  though  perhaps  held 
technically  innocent. 

One  way  in  which  this  sentiment  attributing  some 
sort  of  ethical  responsibility  to  trustees  of  corporation 
mortgages  manifests  itself  is  through  slight  alterations 
in  the  wording  of  the  mortgage  itself.  The  old  lan- 
guage was  that  the  trustee  was  to  be  held  harmless 
under  all  circumstances.  Now  the  trustee  is  often 
found  willing  to  assume  responsibility  at  least  for  gross 
negligence  or  for  the  negligence  of  servants  or  clerks 
not  carefully  selected.  If  to  some  such  phrases  be 
added  a  more  careful  drawing  of  the  mortgage  as  to  its 
provisions  against  unauthorized  issues  of  bonds,  a  bet- 
ter compliance  with  the  ethics  of  the  situation  would  be 
had  ;  for  it  is  undeniable  that  a  part  of  the  public  com- 
plaint against  the  fraudulent  issue  of  bonds  should  be 
directed  against  the  inadequate  safeguards  imposed  in 
the  mortgage  rather  than  against  the  trustee. 

As  an  example  of  what  is  meant  may  be  taken  a 
mortgage  which  we  will  say  may  be  issued  for  the 
purpose  of  improving  a  railroad,  though  the  proceeds 
of  the  bond  when  sold  may  be  devoted  toward  an 
entirely  difierent  object,  one,  we  will  say,  tainted  with 


Railway  Bonds  6 1 

fraud.  Sucli  a  fraudulent  misuse  of  company  borrow- 
ings would  be  checked  at  the  outset  if  the  mortgage 
had  contained  sections  limiting  the  amount  of  money 
which  should  be  expended  in  any  one  year,  and  pro- 
viding that  the  trustees  should  not  certify  to  any  of 
the  bonds  until  a  certificate  had  been  filed  with  the 
trust  company,  signed  by  the  chief  engineer,  stating 
that  a  certain  amount  of  work  had  been  done  or  a 
certain  number  of  miles  of  new  road  or  new  track  con- 
structed. This  statement  of  the  chief  engineer  could 
have  been  accompanied  by  an  affidavit,  signed  by  the 
president  and  treasurer  of  the  company,  to  the  effect 
that  the  allegations  of  the  chief  engineer  were  true. 
Provisions  of  this  character,  varied  according  to  the 
circumstances  of  each  case,  but  to  the  same  intent, 
should  be  inserted  in  every  mortgage  which  contem- 
plates the  spending  of  new  money  for  corporation  uses. 
Restrictions  such  as  these  would  protect  the  trustee  ; 
while  at  the  same  time  rendering  the  officers  clearly 
responsible  to  the  public  and  to  the  law  for  any  lapse 
of  corporation  duty  as  to  any  issue  of  bonds  whenever 
a  fraudulent  or  unauthorized  use  of  the  money  was 
thus  guarded  against.  The  two  ideas  of  better  care  on 
the  part  of  the  trustees  of  corporation  mortgages,  and 
of  better  definition  of  the  terms  and  conditions  under 
which  the  money  is  to  be  borrowed  and  used,  go  to- 
gether. Both  are  essential  unless  we  are  willing  to 
entrust  the  whole  matter  to  the  good  faith  and  to  the 
interpretation  put  upon  responsibility  by  those  con- 
cerned. The  necessity  of  granting  to  the  directors 
chosen  by  the  stockholders  to  manage  the  property,  at 
least  a  proper  amount  of  liberty  in  that  management 
is  obvious  ;  but  that  concerns  the  shareholders,  not  the 
creditors.     Good  corporation  financiering  requires  that 


62  Corporation  Finance 

money  be  borrowed  on  tbe  best  possible  terms.  Since 
bondholders  do  not  wish  to  concern  themselves  with 
questions  of  success  or  failure  in  management,  they  are 
best  pleased  with  investments  which  are  surrounded 
with  all  possible  money  safeguards.  Cheap  borrowing 
demands  that  the  prejudices  of  capitalists  be,  within  all 
reasonable  limits,  regarded. 

The  listing  of  bonds  and  shares  on  the  exchanges  is 
of  benefit  to  both  corporations  and  investors.  A  wider 
market  is  thus  made  for  those  who  wish  to  buy  or  to 
sell.  One  of  the  advantages  of  corporation  securities, 
and  one  which  gives  to  them  a  higher  range  of  values 
than  they  otherwise  would  obtain,  is  the  ease  and 
rapidity  with  which  sales  can  be  made.  Real  estate, 
for  instance,  with  all  its  good  points,  has  the  drawback 
that  it  cannot  be  quickly  turned  into  cash  at  need.  In 
like  manner  a  mortgage  on  country  property  cannot  be 
used  at  the  banks  as  collateral  for  loans,  nor  can  a 
mortgage  on  good  city  property  always  be  easily  dis- 
posed of.  Bonds  and  shares  of  corporations  which  can 
be  listed  on  the  exchanges  have  at  once  a  standing  (not 
value)  which  gives  them  a  market  at  some  price  always. 
Corporations  which  issue  bonds  and  shares  intended 
for  public  purchase,  should  list  such  issues  whenever 
possible.  j^ 


CHAPTER  IV. 

SUBSIDIARY  COMPANIES   AND    TH^IR  SKCURITI^S. 

OUR  American  systems  of  railways  are  matters  of 
growth.  They  usually  consist  of  a  number  of 
smaller  roads  once  independent  which  have  been  joined 
together  by  purchase  or  by  consolidation.  Where  these 
lines  are  continuous  their  status  does  not  need  discus- 
sion. The  origina]L,]ponds  of  such  lines  are  recognized 
as  having  a  prior  lien  which  cannot  be  disputed,  and  as 
such  they  command  very  high  quotations  on  the  stock 
exchanges  ;  but  in  addition  to  old  roads  which  now 
form  a  part  of  the  existing  main  line,  nearly  all  our 
systems  have  branch  roads,  which  at  greater  or  less 
length  reach  from  the  main  line  into  some  agricultural 
section  or  to  mines  or  to  cities.  In  this  way  facilities  of 
transportation  are  afforded  to  the  sections  thus  reached, 
while  the  main -line  traffic  is  increased.  It  is  only  lately 
that  the  importance  of  well-located  branch  lines  to  Ijie 
main  stem  has  been  appreciated  in  the  public  mind. 
The  capacity  of  the  main  line  of  a  railway  for  carrying 
a  large  quantity  of  traffic  is  very  great,  being  practi- 
cally limited  only  by  the  amplitude  of  the  terminals. 
Every  additional  car  which  may  be  added  to  trains  that 
must  be  run  in  any  case  is  a  clear  gain  to  the  company  ; 
in  like  manner  the  receipts  from  every  additional  freight 
train  which  the  road  may  receive  up  to  the  limit  of  its 
capacity  are  also  direct  gains  after  deducting  the  train 

63 


64  Corporation  Finance 

or  **  movement  ^'  expenses  ;  for  while  the  latter  may  be 
roughly  estimated  at  forty  cents  a  train  mile,  the  aver- 
age gross  earnings  of  such  a  train  in  the  United  States 
are  about  $1.60  per  mile  run.  The  increasing  profit- 
ableness and  necessity  of  additional  traffic  explains  why 
the  railways  in  the  United  States,  and  particularly 
those  doing  a  small  business  west  of  the  Mississippi 
River,  have  been  led  either  to  build  branch  roads  into 
all  sections  where  extra  traffic  might  profitably  be 
secured  or  to  support  directly  or  indirectly  so  many 
auxiliary  businesses,  farming  or  stock-raising  enter- 
prises, which  might  add  to  the  volume  of  traffic.  So 
clear  has  the  necessity  of  branch  lines  seemed  to  the 
managers  of  the  railways  in  our  newer  States  that  the 
company  which  did  not  build  or  purchase  subsidiary 
enterprises  might  not  expect  to  develop  traffic  in  the 
parts  of  the  country  near  their  lines  ;  indeed,  could  not 
hope  to  hold  their  shipments  against  the  competing  rail- 
ways which  were  active  in  following  out  the  policy  of 
building  such  lines. 

The  profit  accruing  to  the  main  lines  from  the  traffic 
which  they  interchanged  with  the  branch  railroads  was 
great  in  any  case,  and  became  all  the  more  conspicu- 
ously so  when,  as  usually  happened,  the  main  line  was 
benefited  by  the  long  haul  of  hundreds  of  miles  upon 
this  branch-line  business.  Sometimes  these  branch 
railroads  proved  very  expensive  to  build,  as,  for~ex- 
ample,  in  attempts  to  reach  some  mountain  mining  j 
camp  ;  and  whether  expensive  or  not,  the  money  for  i 
their  construction  was  usually  obtained  by  the  issue  of 
branch-line  bonds,  which  may  have  been  guaranteed 
directly  by  the  parent  company  or  were  made  salable 
to  the  public  by  a  lease  or  other  contract,  setting  forth 
in  some  form  the  obligation  of  the  large  road  to  its 


Subsidiary  Companies  :  their  Securities     65 

dependency.  The  majority  of  the  branch  roads  in  the 
old  Northern  Pacific  system,  for  illustration,  were  oper- 
ated under  leases  which  specified  that  the  earnings  of 
the  branch,  even  though  prorated  mile  for  mile,  should 
always  be  equal  to  the  annual  sums  required  for  bond 
interest  and  sinking  funds. 

Where  such  branch  lines  were  built  with  reasonable 
judgment  and  care  there  seems  no  doubt  that  their 
building  was  justified.  Under  the  circumstances  a 
division  of  the  joint  earnings  on  the  basis  of  mile  for 
mile  of  the  whole  distance  carried  would  be,  as  a  cri- 
terion of  its  real  value,  manifestly  unfair  to  the  sub- 
sidiary road.  It  has  been  determined  by  railroad 
custom  for  many  years  that  the  division  of  joint  earn- 
ings between  two  companies  should  be  on  equal  terms 
only  when  the  circumstances  were  equal.  But  when 
the  little  road  is  the  originator  of  the  traffic,  receiving 
that  traffic  from  different  stations  in  small  lots  and 
delivering  it  at  the  junction  point  in  train  loads  to  the 
main  line,  it  is  well  settled  that  the  conditions  are  not 
equal,  and  that  the  branch  line  is  commercially  entitled 
to  more  than  its  mileage  proportion  of  the  through  rate. 
With  a  few  of  its  branches  just  mentioned,  the  North- 
em  Pacific  arranged  to  allow  a  concession  of  two  miles 
on  the  branch  for  every  mile  actually  travelled.  In 
some  cases  of  short  branch  lines  these  have  been 
allowed  to  charge  arbitraries,  as  they  are  called,  /.  ^., 
fixed  sums  regardless  of  the  through  rate,  sums  fixed 
high  enough  to  yield  the  auxiliary  road  fair  earnings. 
In  other  cases  these  branches  have  been  allowed  *  *  con- 
structive '*  mileage,  through  either  an  agreed  percent- 
age of  the  whole  rate,  or  a  proportion  based  upon  two 
or  three  times  the  actual  length  of  the  haul  upon  the 

branch  line.     As  an  illustration  of  the  division  of  eam- 
5  '  •      '• 


66  Corporation  Finance 

ings  by  fixed  percentages,  the  case  of  the  lines  of  the 
Atchison,  Topeka,  and  Santa  Fe  system  in  California 
may  be  taken.  At  the  time  of  the  Atchison  receiver- 
ship in  December,  1893,  ^^  shipments  of  freight  from 
I^os  Angeles,  California,  to  Kansas  City,  Missouri,  five 
cents  per  hundred  pounds  were  allowed  as  a  terminal 
charge  in  I^os  Angeles ;  the  California  lines  were 
(after  deducting  the  terminal  charge)  then  credited 
with  nineteen  per  cent,  of  the  through  revenue.  The 
remainder  of  the  through  charge  was  then  divided  on  a 
mileage  basis  between  the  other  roads  in  the  system 
carrying  the  traffic.  On  a  mile-for-mile  basis  the  Cali- 
fornia lines  would  have  received  but  about  eight  per 
cent,  of  the  total  charge.  An  example  of  purely  con- 
structive mileage  is  that  of  the  allowance  by  the  Union 
Pacific  main  line  to  the  Oregon  Short  lyine  (a  part  of 
the  Union  Pacific  system)  of  i^  miles  for  each  one 
mile  of  actual  haul.  To  show  the  results  of  construct- 
ive mileage  in  practice  a  supposititious  case  may  be 
taken.  If  a  branch  road  is  one  hundred  miles  long  and 
the  freight  which  it  originates  is  hauled  a  distance  of 
five  hundred  miles  on  the  main  line  (the  freight 
charges  being  based  in  the  first  place  upon  the  com- 
mercial conditions),  strict  mileage  proportion  would 
require  that  the  branch  road  should  receive  one  sixth 
of  the  total  charges.  If  the  constructive  mileage  of  two 
miles  for  one  were  allowed  to  the  auxiliary  roads  its 
haul  would  be  considered  as  two  hundred  miles  for  the 
purpose  of  the  calculations,  the  main  line  having  the 
same  mileage  as  before,  five  hundred  miles  ;  this  would 
give  the  little  road  two  sevenths  of  the  same  total 
receipts.  Out  of  joint  earnings,  amounting  to  $1000, 
the  former  method  would  give  the  branch  $166.67, 
while  constructive  _aileage  of  two  for  one  would  yield 


Subsidiary  Companies  :  their  Securities     67 

$285.71,  the  difference,  $119.04,  being  a  net  increase- 
that  is,  an  increase  of  earnings  without  an  increase  of 
expenses.  Sometimes  three  miles  for  one  are  allowed 
the  auxiliary  company.  But  few  branches  have  so  long 
a  proportionate  haul  as  one  hundred  miles.  In  cases 
where  the  distance  to  the  junction  of  the  main  line  is 
very  short,  the  branch  is  allowed  in  the  calculations  a 
minimum  distance  of  say  fifty  miles.  It  occasionally 
happens  that  roads  having  a  long  mileage  are  by  reason 
of  their  circumstances  really  to  be  considered  in  the 
light  of  branches  and  entitled  to  more  than  a  strict 
mileage  proportion  of  the  revenues  received  from  the 
traffic  carried  over  their  own  and  other  lines  on  a 
through  rate.  The  case  of  the  Oregon  Short  I^ine,  just 
cited,  is  an  example.  What  proportions  are  equitable 
in  any  particular  case  can  only  be  determined  by  a 
careful  study  of  all  the  circumstances,  and  by  consult- 
ing the  judgment  of  those  who  by  long  experience  are 
familiar  with  the  customs  of  the  railways  in  these 
respects. 

When  the  Chicago,  Burlington,  and  Quincy  Railroad 
was  built  west  of  the  Missouri  River,  the  Nebraska 
lines  received  half  of  the  through  rate  for  the  average 
haul  of  135  miles,  as  against  the  other  half  received  by 
the  old  main  line  for  its  haul  of  486  miles.  Illustra- 
tions of  this  sort  abound  in  our  railroad  history.  Nor 
are  they  new.  A  dozen  years  ago  the  legislature  of 
Illinois  investigated  the  practice  of  the  Illinois  Cen- 
tral Railroad  in  allowing  constructive  mileage  to  its 
branches,  on  complaint  that  the  State,  which  was 
entitled  to  seven  per  cent,  of  the  gross  earnings  of  that 
company,  was  by  this  policy  losing  the  sums  due  to  it. 
The  committee  reported  that  this  method  of  encourag- 
ing the  building  of  branches  by  the  Illinois  Central 


68  Corporation  Finance 

really  increased  the  revenues  of  the  main  line  and 
therefore  of  the  State.  The  case  is  even  stronger  than 
this.  It  was  estimated  by  the  United  States  Pacific 
Railway  Commission  in  1887  that,  on  the  traffic  inter- 
changed by  the  Union  Pacific  Railway  with  its  branches, 
the  profit  to  the  main  line  was  in  the  aggregate  nearly 
twice  as  much  as  that  derived  from  the  business  origi- 
nating on  its  own  main  lines.  The  testimony  before 
that  Commission  was  to  the  effect  that  without  its  sys- 
tem of  branches  the  Union  Pacific  would  have  been 
then  bankrupt. 

Since  the  large  systems  were  under  the  necessity  of 
building  or  acquiring  branch  lines  in  order  that  their 
main  lines  might  have  a  volume  of  traffic  sufficient  to 
make  its  carriage  a  financial  success,  it  was  soon  seen 
that  the  position  of  these  branches  as  regards  the  main 
stems  must  be  defined  commercially  before  the  money 
for  their  building  could  be  obtained.  The  owner  of  a 
branch-line  bond  was  quick  to  see  that  he  was  depend- 
ent for  the  value  of  his  property  upon  the  main  line  ; 
for  while  the  branch  company  held  a  contract  of  some 
sort  with  the  parent  company,  the  obligation  of  that 
contract  came  after  the  mortgages  which  had  been  or 
might  be  put  upon  the  main  lines,  and  hence  might  be 
disavowed  in  time  of  financial  distress.  Such  a  breach 
of  contract  would  leave  the  branch-line  holder  without 
an  adequate  commercial  remedy.  In  this  way  the 
necessity  of  putting  a  constructive  valuation  upon  aux- 
iliary properties,  joined  with  the  acknowledged  business 
equities  of  the  subject,  led  to  the  granting  of  a  more  or 
less  defined  position  to  subsidiary  companies  which 
could  be  sustained  before  the  courts.  Thus  the  holder 
of  the  bonds  or  other  obligations  of  auxiliary  companies 
I  was  assured  of  a  financial  value  to  his  holdings  equiva- 


Subsidiary  Companies  :  their  Securities     69 

lent  to  their  commercial  value  as  ascertained  by  a  \ 
consensus  of  railway  opinion.  This  valuation  being  ' 
somewhat  indefinite,  the  market  quotations  for  the 
bonds  of  branch  railway  lines  are  influenced  in  part  by 
the  known  advantages  of  the  branch  line  in  question, 
and  in  part  by  the  general  opinion  as  to  the  honor  of 
the  system  managers  and  the  ability  of  the  company  to 
earn  the  required  revenues. 

The  necessity  of  branches,  particularly  in  the  de- 
veloping sections  of  the  country,  being  admitted,  it 
follows  that  the  values  of  those  branches  and  the  bonds 
upon  them  are  not  to  be  determined  by  the  form  of  con- 
tract under  which  they  are  operated.  In  a  large  number 
of  instances  the  exact  commercial  worth  of  each  sub- 
sidiary company  is  not  statistically  worked  out  by  the 
controlling  system.  It  is  often  considered  sufficient  if 
a  lease  is  made  under  which  it  is  mutually  agreed  that 
the  earnings  of  the  branch  shall  always  be  equal  to 
annual  interest  on  the  bonds.  Then  the  joint  earnings 
may  be  divided  as  may  be  most  convenient  for  the 
bookkeeping,  usually  on  a  **  straight  mileage  '*  basis, 
mile  for  mile.  Under  such  accounting  the  branch  line 
would  show  each  year  a  deficit  in  earnings  under  fixed 
charges  which  under  its  lease  the  main  company  would 
take  from  its  general  treasury.  Obviously  such  book- 
keeping, though  not  intended  to  mislead,  would  not 
be  a  proper  basis  for  estimating  the  commercial  value  of 
the  branch  property  or  of  its  bonds.  At  best  it  is  a  slov- 
enly way  of  accounting.  Usually  it  is  adopted  merely 
to  save  the  trouble  of  obtaining  expert  opinion  as  to  the 
true  division  of  joint  earnings.  The  books  and  statis- 
tics of  large  companies,  railway  or  manufacturing, 
ought  to  be  so  kept  and  the  public  reports  so  made,  as 
to  show  as  exactly  as  possible  the  real  earnings  or 


70  Corporation  Finance 

losses  of  the  system  as  a  whole  and  of  each  particular 
branch  line  or  subsidiary  property  not  merged  into 
the  old  company. 

The  inadequacy  of  this  old  style  of  accounting  be- 
comes of  practical  importance  in  cases  of  insolvency  or 
where  through  the  expiration  of  a  lease  a  readjustment 
is  to  be  made.  The  Board  of  Directors  in  the  latter  case 
may  seek  to  compel  the  branch  bondholders  to  accept  a 
reduction  in  the  interest  rate  to  correspond  with  the 
earnings  of  the  branch  road  as  shown  on  the  system's 
books.  Or  when  a  reorganization  is  necessary  and  the 
capitalization  of  the  whole  system  must  be  reduced,  the 
problem  of  dividing  that  reduction  among  all  the 
obligations  of  the  system  becomes  very  complicated. 
If  the  real  earnings  of  the  diflferent  parts  of  the  system 
are  to  be  taken  as  the  basis  for  the  new  capitalization, 
the  holders  of  bonds  of  branch  Hues  which  show  de- 
ficits may  be  asked  to  submit  to  many  sacrifices  of 
principal  and  interest.  A  case  in  point  is  that  of  the 
Atchison,  Topeka,  and  Santa  Fe  system  before  referred 
to.  It  will  be  remembered  that  the  lines  in  California 
were  allowed  a  fixed  percentage — nineteen  per  cent. — 
of  the  through  charge  on  shipments  between  lyos  Ange- 
les, California,  and  Kansas  City,  Missouri,  and  that  the 
remainder  of  the  through  charge  was  divided  between 
the  other  carrying  companies  mile  for  mile.  These 
other  lines  between  the  points  named  consisted  of  the 
Atlantic  and  Pacific  from  Barstow,  California,  to  Albu- 
querque, New  Mexico,  about  747  miles,  and  the  Atchi- 
son main  line  thence  to  Kansas  City,  about  920  miles. 
To  secure  the  connecting  line,  the  Atlantic  and  Pacific, 
the  Atchison  Company,  jointly  with  another  company, 
had  guaranteed  interest  on  the  Atlantic  bonds ;  a 
necessary    measure,  for  under  the  mile-for-mile  con- 


Subsidiary  Companies  :  their  Securities      71 

tract  and  because  of  light  local  traffic  and  heavy  operat- 
ing expenses,  this  connecting  line  up  to  the  date  of 
the  receivership  had  shown  large  deficits  under  fixed 
charges  which  were  made  good  by  the  guarantors. 
When  reorganization  became  necessary  in  1895,  the 
bondholders  of  the  Atlantic  and  Pacific  were  unwilling 
to  accept  the  deficits  under  the  bookkeeping  as  prov- 
ing the  small  value  of  their  property,  claiming  that  the 
commercial  and  fair  worth  had  never  been  properly  de- 
termined by  the  Atchison  system  when  solvent.  In 
such  cases  the  only  sure  ground  for  determining  the 
values  of  auxiliary  properties  or  for  refusing  acquies- 
cence in  a  new  lease  or  in  a  reorganization  plan,  is  the 
real  commercial  earning  power  or  importance  of  the 
property  in  dispute.  If  such  power  has  never  been 
ascertained  in  the  manner  already  indicated,  the 
holders  of  bonds  need  not  consent  to  a  reduction  until 
such  appraisement  has  been  made  by  competent  author- 
ities. There  is  every  chance  for  fierce  disputes  at  just 
this  point ;  for  in  cases  of  bankruptcy  the  owners  of 
roads  on  the  main  lines  naturally  look  upon  their  lien 
as  paramount  to  obligations  of  any  kind  due  to  sub- 
sidiary companies  ;  and  technically  they  are  of  course 
right.  But  the  question  at  once  arises  :  whence  comes 
the  traffic  which,  moving  over  the  main  lines,  yields 
the  earnings  on  which  the  senior  mortgage  has  the 
first  claim  ?  If  from  the  stations  on  the  main  lines — 
if  it  is  strictly  '*  local  " — the  branch  holders  may  be 
told  to  ''  take  their  road.'*  But  if,  as  often  happens, 
the  figures  prove  that  an  important  part  of  this  traffic 
is  interchanged  with  branch  roads,  as  in  the  case  of 
the  Union  Pacific  before  mentioned,  then  those  branch 
lines  are  entitled  to  an  equitable  share  in  the  prosper- 
ity of  the  system  whatever  that  may  be  ;  a  share  to  be 


^^ 


72  Corporation  Finance 

decided  by  the  proportion  whicli  branch-line  earnings 
properly  determined  bear  to  the  whole.  For  these 
reasons  the  question  of  the  real  value  of  branch  lines 
and  branch-line  bonds,  when  not  settled  until  insolvency 
or  termination  of  a  lease,  gives  rise  to  endless  contro- 
versies. And  yet  the  obligations  of  subsidiary  com- 
panies when  based  upon  values  which  by  custom  have 
come  to  have  a  substantial  basis,  are  safe  investments  ; 
though  those  values  ought  to  be  established  through 
accurate  statistics  from  the  ver>'  beginning. 

It  thus  appears  that  branch  lines  are  necessary  to 
the  development  of  the  railway  "systems  of  our  newer 
States  and  equally  a  necessity  to  the  growth  in  wealth 
of  the  sections  of  the  country  traversed  by  them.  It 
also  appears  that  certain  of  these  branches  may  have 
shown  a  yearly  deficit  under  their  own  fixed  charges, 
although  the  indirect  benefits  to  the  main  lines  may 
have  been  greater  than  the  deficits  paid  from  the  com- 
pany's treasury.  In  such  case,  however  the  accounts 
may  be  kept,  the  total  result  is  a  gain  to  the  system. 
The  question  now  arises,  how  should  these  deficits  be 
treated  in  the  company's  books?  In  some  instances 
railways  have  preferred  that  the  gross  earnings  should 
at  first  be  reported  as  favorably  to  the  main  lines  as 
possible  in  order  that  these  might  make  a  better  show- 
ing. Sometimes  controlling  companies  in  making  up 
their  accounts  for  the  year  omitted  those  branch-line 
losses  from  their  income  statements,  charging  them 
instead  as  '*  loans"  to  subsidiary  companies  or  as 
*  *  investments ' '  in  branch-line  bonds  and  stocks. 

It  would  not  be  equitable  to  condemn  every  instance 
of  this  kind.  If  a  reasonable  expectation  existed  that 
the  increase  of  trafiic  upon  a  new  branch  would  in  a 
year  or  two  be  such  that  the  owning  company  would  be 


Subsidiary  Companies  :  their  Securities     73 

reimbursed  for  such  branch-line  advances,  the  policy 
of  carrying  such  deficits  as  loans  for  a  short  time  might 
properly  be  followed.  Instances  may  be  found  in  the 
history  of  the  lyouisville  and  Nashville  Railroad  where 
some  branch  lines  wisely  projected  but  which  did  not 
yield  in  the  first  year  or  two  direct  income  sufficient  to 
pay  the  accruing  bond  interest,  soon  developed  traffic 
enough  to  pay  back  to  the  parent  company  the  full 
amount  of  all  fixed  charges  from  the  beginning. 

But  railway  managers  are  perforce  optimistic,  and 
share  owners  are  naturally  desirous  of  the  best  possible 
returns  from  their  holdings  ;  so  managers  were  led  to 
continue  the  practice  once  begun  of  charging  branch- 
line  losses  to  capital  instead  of  deducting  them  from 
income.  So  dividends,  or  perhaps  bond  interests,  were 
paid  year  by  year  on  alleged  earnings  of  the  main  line, 
when  in  fact  such  earnings  were  annually  overstated. 
The  lyouisville  and  Nashville  Railroad  just  mentioned 
is  an  instance  of  this  latter  policy  also  ;  for  in  1894  it 
began  for  the  first  time  to  deduct  from  its  profit-and- 
loss  statements  the  losses  on  one  of  its  main  branches 
which  it  had  for  years  beeen  carrying  as  '*  assets" 
in  an  optimistic  hope  that  the  amounts  *'  advanced" 
to  the  branch  would  be  made  up  from  increased  earn- 
ings. In  that  same  year,  1894,  the  New  York,  I^ake 
Erie,  and  Western  began  also  for  the  first  time  to  de- 
duct the  losses  of  its  auxiliary  companies  from  its  main- 
line income  account.  The  policy  of  carrying  branch- 
line  deficits  as  assets  in  the  general  balance-sheet  was 
carried  out  systematically  by  the  Richmond  and  West 
Point  Terminal  Railway  and  Warehouse  Company. 
Those  who  wish  to  follow  the  matter  further  will  find 
abundant  illustration  in  the  records  and  reports  of 
that  company  and  of  the  railways  embraced  in  its 


74  Corporation  Finance 

control.  In  this  way  *' investments  "  in  branch-line 
roads  or  other  subsidiary  property  were  increased  on 
one  side  of  the  ledger,  to  be  balanced  by  an  equal 
increase  of  funded,  floating,  or  current  debts  on  the 
other.  It  was  inevitable  under  such  a  system  of 
accounting  and  of  dividend  paying  that  the  real  weak- 
ness of  a  system  should  be  revealed  at  the  first  touch 
of  adversity.  It  usually  happens  that  the  limit  of  credit 
to  such  a  company  comes  at  the  very  time  when  good 
credit  is  essential  in  order  to  tide  affairs  over  a  tempo- 
rary decline  in  profits.  No  more  money  can  be  bor- 
rowed, for  the  borrowing  powers  have  been  exhausted 
in  order  to  collect  funds  for  past  payments  to  bond-  or 
stockholders  ;  a  receivership  then  becomes  unavoidable 
and  the  true  state  of  things  becomes  publicly  known. 
/ 1   A  few  systems,  some  only  when  really  insolvent  and 

I^me  while  solvent,  have  adopted  the  policy  of  charg- 
ing off  against  surplus  income  the  losses  of  auxiliary 
.^ompanies  which  had  been  accumulating  perhaps  for 
itnany  years.     Such  housecleaning  should  be  general. 

healthy  financial  opinion  regarding  the  wisdom  of 
conservatism  in  estimating  profits,  is  not  the  least  of 
the  good  effects  of  business  depression.  Among  sys- 
tems which  have  pursued  a  rash  course  so  long  that 
the  holdings  of  shares  are  endangered,  it  is  useless  to 
hold  the  accounting  department  responsible.  As  re- 
marked, the  process  of  debiting  or  crediting  items  to 
certain  accounts  on  certain  ledgers,  is  simple  ;  the  real 
difiiculty  lies  in  putting  a  correct  opinion  upon  the 
items  themselves  and  in  formulating  a  clear  mercantile 
theory  about  them  and  that  which  they  represent. 

In  a  large  number  of  cases  the  parent  company,  in 
order  to  create  a  market  for  branch-line  bonds  or  to 
buy  the  control  of  certain  independent  roads,  has  guar- 


Subsidiary  Companies  :  their  Securities     75 

anteed  the  payment  of  interest  on  these  bonds  as  well 
as  payment  of  the  principal  at  maturity.  In  our  corpo- 
ration history  there  have  been  instances  of  the  repudia- 
tion of  such  guaranties,  and  the  question  of  their  com- 
mercial value  is  raised  in  the  reorganization  of  nearly 
every  large  system.  The  forms  of  words  which  contain 
this  guaranty  are  many.  **  For  value  received''  is 
perhaps  the  most  common,  the  usual  meaning  of  that  , 
phrase  being  that  the  traffic  connection  gives  to  the  / 
guaranteeing  company  an  equivalent  for  its  obligation. 
In  certain  cases  the  language  means  merely  that  the 
parent  company  agrees  that  the  interest  shall  be  paid 
to  the  bondholders  ;  it  then  sometimes  happens  that 
the  obligating  company  purchases  the  coupons  without 
cancelling  them.  By  this  method  the  lien  of  interest 
would  not  be  discharged  but  kept  alive  ;  and  at  the 
maturity  of  the  mortgage  these  purchased  coupons  are 
legally  entitled  to  rank  with  the  bonds  in  claiming  part 
of  the  property.  An  instance  may  be  found  in  the  his- 
tory of  the  consolidation  of  the  former  roads  into  the 
Pittsburgh,  Cincinnati,  Chicago,  and  St.  I^ouis  Railway 
Company  in  1890.  The  practical  effect  of  such  purchas- 
ing is  to  weaken  the  value  of  the  bonds  to  that  extent. 
The  guaranteeing  company,  however,  cannot  **  pur- 
chase ' '  coupons,  but  must  pay  and  cancel  them  unless 
there  is  express  authority  for  the  former  course. 

Other  forms  of  guaranty  recite  certain  specific  con- 
siderations or  refer  back  to  certain  conditions  not  given 
in  the  endorsement  on  the  bond  but  contained  in  the 
resolutions  of  the  Board  of  Directors  and  not  easily 
accessible  to  the  public.  If  the  matter  is  of  importance, 
it  is  advisable  for  all  holders  of  guaranteed  bonds  to 
consider  the  form  of  guaranty  carefully  and  to  obtain 
and  read  the  proceedings  of  the  different  boards  of 


76  Corporation  Finance 

directors  or  officers  or  committees  which  have  dealt 
with  the  subject.  In  this  way  a  clear  idea  may  be 
obtained  of  the  nature  of  the  obligation  and  of  the  con- 
sideration which  has  been  given  for  that  obligation. 
The  courts  have  always  upheld  and  enforced  the 
I  guaranties  of  railway  companies  whenever  that  was 
^legally  possible  ;  still,  if  a  company  resolves  to  repudi- 
ate its  obligations,  it  will  often  find  a  legal  reason  for 
so  doing.  The  laws  governing  such  transaction  in  the 
several  States  are  sometimes  conflicting,  and  the  ques- 
tion of  the  applicability  of  this  or  that  statute  or  section 
of  the  constitution  to  a  particular  case  is  often  so  much 
in  doubt  that  the  question  of  lack  of  power  to  make 
such  a  contract  or  to  enter  into  such  a  guaranty  is 
easily  raised  if  a  company  needs  to  do  so ;  and  it  is 
often  hard  to  settle.  The  innocent  holder  of  repudiated 
bonds  is  entitled  to  the  benefit  of  every  doubt  and  usu- 
ally gets  that  benefit ;  but,  as  before  stated,  if  a  com- 
pany decides  to  dishonor  its  promises,  the  legal  points 
it  may  raise  are  many,  and  the  result  not  always  clear. 
The  repudiation  by  the  Evansville  and  Terre  Haut€< 
Company  in  1894  of  its  guaranty  on  Evansville  anc 
Richmond  bonds  is  in  point.  In  estimating  the  valuC' 
of  guaranteed  bonds,  therefore,  the  holder  must  takci 
into  consideration  the  general  reputation  for  good  fai' 
and  solvency  which  the  company  bears  in  the  opini( 
of  the  financial  public. 

There  have  been  instances  in  our  corporation  exper 
ence  in  which  companies  have  justified  their  repudiatii 
of  guaranties  by  a  general  argument.  That  argumeni 
usually  runs  thus  :  '*  A  company  has  guaranteed  th 
almost  perpetual  paj^ment  of  certain  interest.  At  th 
time  such  an  agreement  was  made  the  circumstance 
justified  the  bargain  ;  the  branch  taken  over  was  wort 


Subsidiary  Companies  :  their  Securities     "jy 

to  the  main  company  all  tliat  was  annually  to  be  paid 
for  it.  But  in  a  few  years  business  changed  greatly  ; 
another  road  was  built  into  the  branch's  territory,  or 
the  mine  or  manufacturing,  for  which  the  branch  was 
projected,  gave  out.  In  fine,  the  yearly  result  to  the 
guaranteeing  company  is  now  a  heavy  deficit  imder  the 
agreed  rental.  Should  the  company  be  kept  to  the 
letter  of  its  contract  no  matter  what  happens,  or  should 
the  branch  share  in  the  common  loss  ?  The  equity  of 
a  continuing  contract  is  a  thing  yet  commercially  unde-  / 
termined.  In  business  afiairs  most  continuing  contracts- 
which  involve  loss  upon  either  party  are  settled  either 
by  a  compromise  or  by  the  insolvency  of  the  losing 
party.  In  trade  the  instances  are  very  few  indeed 
where  such  losses  are  paid  regularly  year  by  year 
indefinitely.  It  is  true  that  for  obvious  reasons  the 
courts  always  insist  upon  the  letter  of  a  contract  because 
the  sacredness  of  contracts  is  vital  to  business  ;  yet  the 
statement  that  no  machinery  exists  for  determining 
such  questions  does  not  alter  the  fact  that  the  common- 
sense  of  mankind  is  against  the  enforcement  of  such 
unfair  contracts  running  indefinitely.  The  principle  is 
the  same  as  that  which  allows  a  debtor  to  escape  his 
debts  under  certain  conditibns,  because  it  would  be 
hopeless  and  cruel  to  keep  a  man  in  jail  or  even  in  debt 
for  his  whole  life.  That  no  such  rule  exists  for  corpo- 
rations merely  shows  that  corporation  law  has  not  got 
that  far  ;  meanwhile  suffering  companies  try  to  reach 
precisely  that  end  through  legal  quibbles  and  consider 
themselves  commercially  entitled  to  carry  their  purpose 
out  if  possible." 

Arguments  like  these  have  convinced  a  few  thinkers, 
and  in  consequence  propositions  are  sometimes  heard 
that  continuing  guaranties  should  be  made  adjustable 


yS  Corporation  Finance 

as  to  percentage  of  returns  every  ten  or  twenty  years. 

(The  lease  of  the  Central  Pacific  to  the  Southern 
Pacific  was  so  drawn.  The  argument  of  a  defaulting 
corporation  is,  however,  usually  weakened  by  the  facts 
of  the  case.  A  company  wishes  at  the  time  to  build  a 
new  line  or  buy  control  of  one  already  existing.  The 
situation  is  carefully  considered  by  the  officers  and 
directors  and  the  degree  of  necessity  decided  upon. 
That  company  must  pay  for  that  line,  and  must  agree 
with  the  money-lenders  or  the  owners  as  to  terms.  If 
it  could  borrow  money  on  its  guaranty  at  five  per  cent., 
let  us  say,  but  could  not  induce  the  capitalists  to  build 
the  line  and  take  their  chances  without  a  guaranty  at 
less  that  ten  per  cent.,  let  us  suppose,  then  clearly 
enough  the  five  per  cent,  saved  annually  by  guarantee- 
ing the  bonds  is  a  part  of  the  consideration  though  it 
may  not  be  mentioned  in  the  documents  ;  the  saving  is 
of  the  nature  of  an  insurance  given  by  managers  who 
ought  to  know  what  they  are  doing.  If  now  the  expect- 
ations of  these  managers  be  not  realized,  it  is  not  sim- 
ple equity  to  demand  a  readjustment.  If  that  had  been 
the  idea  originally,  the  investors  would  have  demanded 
much  higher  returns  at  the  start.  Readjustments  have 
never  been  in  commercial  favor  even  when  provided  for 
in  contracts.  The  statistics  are  in  the  hands  of  one  of 
the  parties,  the  other  being  able  to  get  but  slight 
knowledge  of  the  real  facts.  For  these  reasons  capital- 
ists have  been  unwilling  to  accept  adjustable  guaran- 
ties, considering  them  not  so  much  inequitable  as 
uncertain  and  indefinite. 

It  follows  from  what  has  been  said  that  guaranteed 
bonds  are  often  safe  but  sometimes  not.  It  is  a  mistake 
for  investors  to  buy  bonds  merely  because  they  are 
guaranteed,  and  oftentimes  a  mistake  in  financiering 


Subsidiary  Companies  :  their  Securities     79 


for  companies  to  issue  them  expecting  them  to  find 
favor  on  that  ground  alone.  The  terms  and  conditions 
under  which  the  guaranty  was  given,  the  form  in  which 
the  obligation  is  set  forth,  the  good  faith  of  the  guar- 
anteeing company,  are  all  to  be  carefully  considered. 
In  some  cases  the  replies  to  these  questions  will  be  so 
satisfactory  that  no  further  investigation  need  be  made, 
especially  if  we  believe  the  revenues  of  the  company  to 
be  equal  to  the  fixed  charges  and  something  more  ;  for  I 
the  ability  of  a  company  to  earn  its  interest  is  as  im- 
portant as  its  intention  to  pay  if  earned. 

In  a  large  number  of  cases  it  is  well  for  the  investor 
to  look  a  little  further  and  for  the  company  to  ask  him  to 
do  so.    The  question  in  such  an  investigation  is :    Does 
the  guaranty  represent  the  commercial  situation  ?    Qges  I  \  ' 
the  branch  line  really  earn  the  interest  on  its  bonds  ?  \  ' 
Is  it  as  it  stands  worth  to  the  guaranteeing  company    \ 
all  that  it  costs  that  company  annually  in  interest  and    ^ 
expenses  ?     If  so,  the  bonds  are,  for  the  time  at  least, 
secure.     This  question  is  in  a  great  many  cases  very 
hard  to  determine.     The  same  neglect  which  has  been 
discussed  in  previous  pages  of  this  chapter  regarding 
branch  lines  whose  bonds  are  not  guaranteed,  follows 
these  guaranteed  roads  also.     Many  companies  have 
not  kept  these  accounts  so  as  to  show  whence  their 
revenues  are  really  derived  ;  such  companies  ought  to 
suffer  in  credit  for  their  carelessness.      The  financial  f 
position  of  branch-line  bonds,  whether  dependent  upon  ' 
the  traffic  of  the  roads  covered  or  upon  the  guaranty 
of  the  main  line,  should  be  clearly  defined.     An  opinion 
as  to  the  value  of  such  branch-line  bonds,  guaranteed 
or  not,  is  then  possible.      The  more  favorable  that 
opinion,   the  better  is  it  for  the  company  which  is 
responsible  for  them. 


CHAPTER  V 

CORPORATION  ACCOUNTING 

EVOI/UTION  in  accounting  is  to  be  expected  the 
same  as  in  the  methods  of  conducting  business. 
As  the  transactions  become  numerous  and  increase  in 
complexity,  a  corresponding  change  in  the  style  of  keep- 
ing the  books  is  demanded.  The  principles  of  book- 
keeping are  simple,  and  the  various  kinds  of  entries  are 
easy  of  general  comprehension.  The  practical  difficulty 
lies  in  making  the  books  set  forth  the  real  facts  ;  for  it 
is  in  judging  of  the  true  meaning  of  those  facts  that  the 
statistician's  art  consists,  the  process  of  recording  the 
figures,  once  the  facts  are  agreed  upon,  being  compara- 
tively easy.  Moreover,  truth  is  many-sided  ;  a  business 
optimist  will  see  things  favorably  and  make  up  his  fig- 
ures accordingly,  while  an  ultra-conservative  merchant 
will  seek  to  have  the  position  of  his  affairs  set  forth  in 
the  most  unfavorable  light.  There  is  the  more  excuse 
for  optimism  in  corporation  matters,  for  corporations 
live  on,  and  having  more  extended  credit,  often  live 
down  losses  which  would  wreck  partnerships  ;  thus 
it  sometimes  happens  that  for  his  own  reputation's 
sake  and  because  of  that  good  credit,  the  manager  of 
a  large  corporation  will  give  to  his  statements  the 
brightest  colors  that  the  circumstances  permit.  For 
these  reasons  criticisms  upon  corporation  reports  are  so 
often  unfavorable  ;  not  because  of  malice  on  the  part  of 

80 


Corporation  Accounting  8i 

the  critic,  so  much  as  of  abounding  optimism  on  the 
part  of  the  usual  corporation  manager.  The  excuse  for 
such  optimism  should  fairly  be  taken  into  account : 
that  there  is  no  hard-and-fast  line  between  fact  and 
credit ;  that  many  a  railway  (for  illustration)  is  helped 
over  a  bad  place  by  its  credit,  and  helped  safely, 
whereas  if  the  exact  truth  were  known,  that  credit 
might  be  destroyed  and  with  it  perhaps  the  whole 
capitalization.  A  little  unwilling  forbearance  on  the 
part  of  creditors  may  bring  everything  around  right 
and  cause  no  loss. 

Every  corporation  must  adopt  such  forms  of  accounts 
as  suit  its  particular  business.  They  should  embrace 
such  a  number  of  separate  books  as  will  enable  the 
management  to  know  exactly  what  is  being  done  in 
every  department  and  in  every  detail  and  at  what  cost. 
The  collection  of  statistics  costs  money,  but  modern 
experience  is  showing  that  only  by  accurate  statistical 
knowledge  can  modern  business  be  successfully  carried 
on.  There  are  good  systems  containing  elaborate  pro- 
visions for  ascertaining  the  various  costs  in  manufactur- 
ing. A  corporation  should  be  more,  rather  than  less, 
exact  than  a  firm.  The  sources  of  profit  down  to  the 
minutest  detail  should  be  carefully  inquired  into  ;  in 
no  other  way  can  the  manager  know  which  class  of 
work  to  encourage,  or  which  to  study  with  a  view  of 
improving  the  process  of  production. 

In  large  companies  the  main  account  is  that  of  the 
general  balance-sheet,  in  which  are  regularly  stated 
the  other  accounts  such  as  surplus  income  or  profit 
and  loss.  Thus  the  balance-sheet  reflects  merely  the 
changes  in  the  general  condition  during  the  year,  not 
the  amount  of  profit.  This  table  or  statement  is  the 
one  upon  which  the  lender  of  money  or  the  investor 

6 


82  Corporation  Finance 

should  bestow  his  careful  scrutiny,  because  on  the 
interpretation  of  the  items  depends  one's  judgment  as 
to  the  solvency  of  the  company.  The  income  table  is 
simply  an  account  of  the  earnings  and  expenses  in 
totals,  together  with  the  proper  deductions  from  the  net 
revenue  for  the  year.  Accompanying  the  income 
account  should  be  tables  explaining  in  full  detail  the 
items  there  given  in  gross.  There  may  be  a  difference 
of  opinion  between  the  managment  and  the  bond-  or 
shareholders  as  to  the  proper  disposal  of  certain  items 
of  expenditure  made  during  the  year.  There  may  be 
a  legitimate  question  whether  such  items  are  properly 
chargeable  to  income  or  not ;  such  questions  are  not 
only  theoretical  but  very  practical,  because  on  their 
answer  often  depends  whether  a  dividend  is  paid  or  not. 
For  such  reasons  the  report  which  every  corporation 
ought  to  make  to  its  shareholders  and  the  public  (if  the 
public  holds  the  shares)  should  contain  statements  in 
sufficient  detail  of  every  transaction  during  the  year, 
whether  included  in  the  income  account  or  not,  in  order 
that  every  one  may  form  his  own  judgment  on  the  wis- 
dom of  the  management  and  the  safety  of  his  invest- 
ment. 

In  cases  where  the  charging  of  items  of  expenditure 
to  the  income  account  may  be  a  doubtful  policy,  or 
where,  from  the  nature  of  the  case,  it  is  difficult  to, 
decide  such  questions,  since  the  answer  may  depend 
upon  one's  opinions  as  to  the  business  prospects  for  the 
future,  the  profit  and  loss  account  offers  an  easy  com- 
promise. To  this  profit  and  loss  account  may  be  cred- 
ited annually  all  the  surplus  earnings  of  the  corporation 
over  and  above  fixed  charges  and  dividends,  or  fixed 
charges  only,  leaving  dividends  for  the  profit  and  loa 
table.     Against  these  surpluses  may  be  charged  froiB 


Corpoi^atzon  Accounting  83 

time  to  time  the  cost  of  unproductive  improvements  ; 
the  deficits  of  subsidiary  companies,  which  for  the  time 
must  be  met  from  the  revenues  of  the  owning  corpora- 
tion ;  sums  which  have  been  included  in  the  earnings 
of  previous  years  and  which  have  now  proved  uncollect- 
ible, and  in  general  all  items  which,  in  the  judgment 
of  the  management,  should  not  be  deducted  from  the 
income  of  the  year,  but  which  good  financiering  re- 
quires should  be  treated  in  the  accounts  in  some  way  as 
debits,  even  if  temporarily,  in  order  that  no  inflation  in 
the  assets  may  occur.  Such  a  profit  and  loss  account, 
if  carefully  and  fully  kept,  will  prove  a  better  test  of 
the  earning  capacity  of  the  company  than  the  income 
account,  which  shows  the  profits  in  any  one  year,  for 
the  reason  that  the  former  table  gives  an  average  of 
results  extending  over  a  number  of  years.  The  annual 
reports  of  the  Denver  and  Rio  Grande  Railway  are 
worthy  of  study  in  this  particular. 

One  of  the  perplexing  things  in  the  financial  man- 
agement of  a  large  manufacturing  or  trading  company, 
is  the  treatment  of  the  expenditures  for  the  care  of  the 
plant.  A  depreciation  account  in  some  shape  must  be 
kept  by  every  company  or  firm  in  business.  The  real 
estate  may  decline  in  value,  and  in  any  case,  in  any 
progressing  concern,  money  will  be  required  to  be 
spent  each  year  to  adjust  the  buildings  more  perfectly 
to  the  requirements  of  the  business,  and  yet  these  ad- 
justments may  not  add  anything  to  the  salable  value 
of  the  property,  and  should  not,  therefore,  be  added 
in  the  accounts  to  the  company's  investment  in  real 
estate.  In  like  manner,  machinery  will  wear  out,  and 
is  always  subject  to  the  danger  of  new  inventions, 
which  may  render  the  old  machinery  practically  worth- 
less.    It  is  not  easy  to  foresee  when  a  new  outfit  will 


1 


84  Corporation  Finance 

be  in  part  or  in  whole  required,  thougli  experience 
soon  places  a  limit  to  the  number  of  years  in  which  a 
given  set  of  machinery  may  be  useful.  The  proper 
course  in  these  cases  is  always  the  conservative  one. 
The  corporation  should  estimate  the  probabilities  of 
depreciation  always  against  itself,  and  set  aside  yearly 
such  sums  from  its  profits  as  will  suffice  to  renew  so 
much  of  the  plant  as  may  be  expected  to  wear  out  or 
to  become  useless  in  a  given  time.  Unless  this  depreci- 
ation fund  is  carefully  thought  out  and  its  separation 
from  profits  rigidly  insisted  upon,  the  shareholders  of 
the  corporation  and  perhaps  the  bondholders  may  in 
the  course  of  years  find  that  their  securities  cover  a 
property  of  little  or  no  business  value.  If  certain  sums 
are  not  set  aside  to  meet  this  depreciation,  and  if  for 
this  reason  dividends  are  paid  larger  than  wo  aid  other- 
wise be  the  case,  to  the  extent  to  which  this  is  carried 
the  returns  received  by  the  shareholders  are  not 
dividends  but  their  capital  returned  to  them  in  piece- 
meal. These  depreciation  sums  should  be  real  and  not 
merely  bookkeeping  liabilities  of  the  company  to  itself. 
Modern  corporation  accounting  requires  that  in  the- 
ory a  sharp  line  of  distinction  should  be  drawn  between 
outlays  which  may  be  considered  a  part  of  the  regular 
working  expenses,  and  those  which  are  chargeable  to 
an  increased  investment  in  the  business.  In  theory  the 
former  should  be  deducted  from  the  gross  earnings 
before  the  net  revenue  is  determined,  while  the  latter 
may  be  met  by  an  increased  issue  of  bonds  or  shares. 
There  is  no  doubt  of  the  correctness  of  this  principle  in 
general,  but  in  its  practical  application  it  is  subject  to 
great  modification.  English  shareholders  in  American 
corporations  usually  insist  upon  such  a  system  of  ac- 
counting as  divides  the  expenditures  strictly  according 


I 


Corporation  Accounting  85 


to  this  rule  ;  and  such  indeed  is  the  general  practice  in  ■ 
Great  Britain.  By  charging  to  capital  every  item  small 
and  large  which  could  by  any  possibility  be  construed 
to  be  a  betterment,  the  British  railways  have  increased 
their  capitalization  until  they  are  dependent  for  a  con- 
tinuance of  interest  payments  on  good  traffics  year  by 
year.  Thus  far  no  harm  has  come  to  these  railways 
from  this  policy,  because  the  fluctuations  in  the  vol- 
ume of  their  traffics  have  been  comparatively  slight. 

But  in  the  United  States  more  caution  must  be 
observed  in  this  matter.  From  the  very  nature  of  the 
case,  business  of  all  kinds  in  a  developing  country  must 
be  more  subject  to  changes  in  profitableness  than  in 
older  countries.  The  very  character  of  the  American 
people,  energetic  and  progressive,  makes  business  all 
the  more  liable  to  such  fluctuations.  Bad  years  follow 
good  years  in  every  line  of  American  industry,  although 
differences  are  less  violent  in  those  trades  which  are 
the  longest  established  and  among  those  companies 
which  have  been  in  operation  long  enough  to  render 
their  business  comparatively  stable.  The  principle, 
therefore,  of  charging  all  so-called  betterments  to  cap- 
ital and  meeting  the  cost  from  the  sale  of  bonds  or 
shares,  requires  modification  according  to  the  circum- 
stances of  each  particular  company.  The  more  fluctu- 
ating the  volume  of  business  has  been  or  is  likely  to  be, 
the  more  important  is  it  that  in  one  form  or  another  a 
part  of  the  profits  in  prosperous  years  should  be  with- 
held from  the  shareholders  and  put  into  the  property  or 
set  aside  for  its  renewal.  To  those  who  wish  a  working 
principle  to  distinguish  the  proper  items  to  be  charged 
to  capital  account  in  the  actual  management  of  Ameri- 
can corporations,  railway  and  other,  the  following 
definition  is  suggested  :    No  additions  to  the  property 


86  Corporation  Finance 

either  to  the  real  estate  or  to  the  machinery  (if  a  manu- 
facturing company),  or  to  the  roadbed  and  track  (if  a 
railway  company),  should  be  considered  betterments 
and  charged  to  capital,  unless  they  increase  the  pro- 
ductivity or  earning  capacity  of  the  plant.  Under  this 
rule  the  purchase  of  additional  equipment  for  a  railway 
would  be  an  expenditure  which  could  conservatively  be 
met  by  the  issue  of  bonds  or  equipment  notes,  because 
such  purchases  would  enable  a  larger  volume  of  traffic 
to  be  handled  ;  on  the  other  hand,  the  replacement  of  a 
wooden  bridge  by  an  iron  one  would  not  be  a  proper 
charge  to  capital,  under  our  definition,  unless  it  was 
"  one  of  a  series  of  expenditures  deliberately  resolved 
upon  in  order  that  heavier  trains  could  be  run  and  a 
larger  volume  of  traffic  handled,  thus  increasing  the 
revenues  of  the  company — an  increase  which  our  theory 
demands  should  be  clearly  seen  to  be  possible  after  the 
various  amounts  of  capital  set  aside  for  this  purpose 
had  been  spent.  The  same  rule  might  be  applied  to 
corporations  other  than  railways  ;  the  safe  course  is  to 
charge  against  revenues  (possibly  through  the  profit- 
and-loss  account)  the  cost  of  all  additions  to  the  prop- 
erty which  do  not  increase  the  output  or  decrease  the 
cost  of  production.  Yet  any  rule  or  any  principle  in  so 
delicate  a  matter  can  properly  be  applied  in  each  case 
only  after  a  careful  study  of  all  the  circumstances, 
including  the  business  of  past  years  and  the  prospect 
for  the  future.  With  railroad  laws  in  nearly  every 
State  permitting  unrestricted  building,  American  rail- 
roads are  constantly  liable  to  attack  by  competing  lines 
projected  for  legitimate  or  speculative  purposes.  In 
England  companies  are  not  chartered  unless  a  public 
necessity  for  the  proposed  line  is  shown.  In  the  United 
States  the  only  safe  course  for  the  old  roads  is  to  make 


Corporation  Accounting  87 

themselves  strong  by  using  a  part  of  their  earnings  for 
betterments,  thus  keeping  down  the  capital  accounts. 
The  Pennsylvania  Railroad  has  pursued  this  policy  for 
forty  years,  having  in  that  time,  according  to  its  re- 
ports, paid  eighty  millions  of  dollars  for  betterments 
>j3ut  of  profits.  The  foreign  shareholders  have  fre- 
quently complained  of  this  policy,  though  experience 
has  shown  it  to  be  an  essential  element  in  the  present 
strength  of  that  company. 

On  railways  the  working  officers  prefer  to  have 
included  in  the  operating  expenses  only  such  sums  as 
may  rightly  be  grouped  under  that  title.  This  is  a 
proper  request  on  the  part  of  the  superintendents, 
because  they  naturally  wish  that  their  administration 
of  the  affairs  of  the  company  should  be  shown  to  be 
conservative  and  careful.  There  is  another  reason  \ 
also  for  keeping  operating  expenses  distinct,  in  that  it ; 
enables  the  managers  to  compare  the  same  items  of 
expenses  year  by  year.  If  these  items  are  varied  by ' 
the  inclusion  or  exclusion  at  times  of  sums  whose 
proper  accountings  may  be  in  doubt,  the  comparison  of 
costs  from  year  to  year  is  vitiated  and  a  valuable  test 
of  the  efficiency  of  the  operating  officers  is  lost.  To 
meet  this  requirement  certain  corporations  deduct  the 
costs  of  such  betterments  as  one  item  from  the  net  rev- 
enue often  in  the  income  statement.  The  objection  to 
this  course  lies  in  the  fact  that  the  sums  thus  expended 
are  lost  sight  of;  and  to  the  extent  to  which  those 
items  are  hidden,  the  real  amount  of  money  spent  upon 
the  plant  is  understated.  This  is  not  a  mere  book- 
keeping objection.  The  railways  have  found  that  the  ^ 
real  cost  of  their  property  is  a  factor  in  dealing  with 
legislatures.  Laws  may  be  passed  in  order  to  reduce 
freight  rates  and  passenger  fares  to  a  point  which  shall 


1 


^ 


88  Corporation  Finance 

yield  the  companies  a  return  *^  on  cost/'  The  same 
point  may  arivSe  at  any  moment  with  companies  other 
than  railways.  Every  corporation  should  therefore  so 
keep  its  accounts  as  to  show  the  amounts  expended  to 
improve  the  plant  year  after  year  from  earnings.  A 
common  custom  is  to  apply  the  annual  surplus  directly 
to  the  construction  charges  for  the  year,  bonds  being 
issued  for  the  amount  of  the  capital  account  after  thus 
deducting  the  surplus.  That  custom  practically  adds 
the  surpluses  spent  for  betterments  to  the  capitaliza- 
tion ;  yet  it  is  a  question  whether  it  would  not  be  better 
to  open  a  comprehensive  profit-and-loss  account,  in 
which  the  cost  of  betterments,  as  well  as  other  indirect 
but  necessary  expenditures,  could  be  included. 
\  Corporations  small  in  capitalization  but  public  in 
their  nature  and  in  their  stock  holdings,  often  conduct 
businesses  which  do  not  require  an  elaborate  system  of 
accounting.  Such  companies  are  often  managed  by 
men  who  are  themselves  large  owners  in  the  property 
and  at  the  same  time  skilled  in  that  particular  trade. 
Such  men,  for  their  own  use  or  for  that  of  the  few  other 
shareholders,  need  only  the  simplest  statements  of  the 
business.  It  is  customary  in  these  small  companies  to 
unite  the  general  balance-sheet  with  the  income  ac- 
count, and  in  their  cases  this  custom  leaves  no  diffi- 
culty. On  the  one  side  are  stated  the  items  of  cost  of 
property,  the  valuation  of  the  tools  and  machinery,  the 
cash  in  the  bank,  perhaps  the  amount  of  interest 
charges  and  dividends  paid  during  the  year,  and  the 
working  expenses.  On  the  other  side  of  the  account, 
the  revenues  of  the  year,  the  bonded  debt,  and  the 
current  debt.  Such  simple  statements  are  well  enough 
for  those  who  understand  the  business  thoroughly, 
while  the  changes  in  the  items  from  year  to  year  allow 


Corporation  Accounting  89 

of  tlie  working  out  of  the 'various  principles  which 
have  just  been  discussed  but  about  which  no  such 
sharp  distinction  need  be  drawn  as  in  the  case  of  large 
manufacturing  companies.  The  original  cost  of  the 
property  can  be  written  off  from  time  to  time  by  adding 
to  the  cash  on  hand  a  yearly  sum  before  dividing 
profits  ;  a  method  of  keeping  a  depreciation  account 
which  meets  the  peculiar  requirements  of  such  com- 
panies as  have  only  a  limited  existence,  such,  for 
instance,  as  those  which  operate  a  mine  where  the 
amount  of  coal  or  ore  can  be  estimated  within  reason- 
able limits.  This  sum  of  money  in  the  bank  is  then 
applicable  to  the  extinguishment  of  the  bonded  or 
share  capital  at  the  proper  time,  or  may  be  used  for 
heavy  improvements  to  the  property  if  such  should  be 
decided  upon.  Small  corporations  which  have  been 
formed  for  family  reasons,  and  whose  shares  are  held 
by  the  former  partners  and  not  sold  to  the  public, 
require  no  special  discussion.  Their  affairs  are  man- 
aged very  much  the  same  as  under  the  former  partner- 
ship. 

The  formation  and  increasing  numbers  of  corpora- 
tions whose  shares  are  held  by  the  public  and  whose 
business  is  trading,  have  led  to  a  more  rigid  system  of 
estimating  mercantile  credits  and  of  inspecting  the 
items  upon  which  that  credit  is  based.  The  evolution 
of  corporation  (or  partnership)  credit  is  one  which  must 
work  for  the  good  of  all  concerned.  Such  companies 
yield  increasing  opportunities  for  the  investment  of 
small  sums,  and  while  thus  gathering  together  the  little 
rivulets  of  capital,  their  managers  should  themselves 
be  under  a  moral  responsibility  to  take  all  the  more 
care  of  other  people's  money.  It  is  well  therefore  that 
the  affairs  of  trading  companies  should  be  subjected  to 


go  Corporation  Finance 

such  analyses  as  will  indicate  their  solvency.  Prepar- 
ing statements  that  will  stand  examination  is  one  of  the 
best  tests  to  which  corporation  managers  submit  as 
tending  to  bring  the  real  position  clearly  before  their 
own  eyes  and  making  them  conservative  in  conducting 
the  business  and  in  estimating  profits  for  the  share- 
holders. Following  this  thought  further,  below  will  be 
found  the  statement  of  a  non-existing  trading  com- 
pany, whose  assets  and  liabilities  may  be  commented 
upon  without  reserve.  The  figures  chosen  for  the  pur- 
pose are  intentionally  doubtful  and  do  not,  of  course, 
reflect  the  real  position  of  our  small  corporations.  They 
have  been  compiled  in  this  form  arbitrarily  and  for  the 
sake  of  comment. 

**  The  Blank  Trading  Company"  we  will  suppose 
was  incorporated  for  the  purpose  of  importing  and  sell- 
ing fancy  goods.  The  statement  below  is  assumed  to 
have  been  made  December  31st  and  the  inventory  to 
have  been  taken  on  the  same  day.  The  head  ofiice  is 
in  New  York  City,  with  branches  in  Boston  and  Chi- 
cago. The  president  of  the  company  is  interested  in  a 
retail  store  in  Chicago,  to  whom  the  company  sells 
goods.  The  statement  of  assets  and  liabilities  of  the 
company  is  as  follows : 

th:^  bIvAnk  trading  co. 

ASSIES 

A.  Cash  on  hand |        600 

B.  Cash  in  Consolidated  and  other  banks 4  000 

C.  BiUs  receivable  (due  from  customers) 7  000 

D.  "            "         (due  from  branches) 10  000 

B.     Accounts  receivable  (due  from  customers) 63  000 

G.     Merchandise  (valued  at  cost) 170  000 

H.     Real  estate 27  000 

J.      Machinery  and  fixtures 800 

K.     Merchandise  in  bonded  warehouses 37  600 

I320  000 


Corporation  Accounting  91 

WABIWTIBS 

p.     Capital  stock  I P;^^^^^^^^^ ^fo  ooo 

^  (.common 50000 

Q.     Bills  payable  for  merchandise 47  000 

R        **           **        to  banks 15000 

S.        **          **        for  commercial  notes  sold 10  000 

T.     Open  accounts 109  000 

V.     Deposits  of  employees 4  500 

X.    Profit  and  loss 34  500 

I320  000 

Some  additional  facts  are  assumed.  A  portion  of  the 
merchandise  in  warehouses  is  subject  to  *'  trust  re- 
ceipts." There  is  a  contingent  liability  (not  shown  in 
the  statement)  of  $20,000  for  endorsed  bills  receivable 
outstanding.  About  $12,000  of  accounts  and  bills 
receivable  is  acknowledged  to  be  past  due.  Sales  the 
preceding  year  amounted  to  $350,000.  Expenses  of 
conducting  the  business  were  $60,000,  and  dividends 
of  eight  per  cent,  upon  preferred  and  twelve  per  cent, 
upon  common  shares,  calling  for  $10,000,  were  paid 
during  the  year. 

First  as  to  the  items  of  the  statement.  Item  A,  cash 
on  hand,  needs  no  particular  comment.  It  represents 
actual  money  in  the  hands  of  the  company.  In  a  few 
instances  where  deliberate  fraud  was  intended  this  item 
has  been  manipulated.  Sometimes  the  words  '*  and 
cash  items ' '  have  been  added  so  that  uncollectible 
bills  or  things  of  that  character  could,  by  a  stretch  of 
language,  be  included.  In  one  instance,  where  a  pay- 
ment was  soon  to  be  made  to  creditors,  a  sum  of  money 
was  borrowed  from  the  bank  and  called  ''  on  hand,'* 
though  the  bank  by  understanding  did  not  allow  the 
cash  to  go  from  its  possession,  retaining  it  at  interest 
over  statement  day.  But  such  cases  are  rare.  ''  Cash  '* 
has  a  recognized  meaning,  and  is  correctly  accounted 


92  Corporation  Finance 

for  by  the  vast  majority  of  companies  and  j&rms.  Item 
B,  cash  in  bank,  also  means  what  it  says,  being  funds 
of  the  company  on  deposit  and  subject  to  cheque  ;  as 
our  company  is  a  reputable  one,  there  is  nothing  to 
cause  doubt  as  to  these  items  of  cash,  A  and  B. 

Item  C,  customers'  bills  receivable  is  a  small  one. 
If  it  were  necessary  to  examine  into  it  closely,  one  ought 
to  know  something  about  the  customers  whose  bills  are 
held  and  the  character  of  the  obligation.  Business 
methods  have  changed  in  recent  years.  It  was  at  one 
time  the  general  custom  to  settle  all  accounts  by  giving 
bills.  Now,  with  the  exception  of  a  few  trades,  it  is 
customary  to  keep  running  accounts,  so  that  the  jobber 
does  not  have  his  customers'  due  bills  as  evidences  of 
money  owing  to  him  as  much  as  formerly.  Of  course,  an 
obligation  signed  by  two  known  firms,  though  one  be 
small,  is  better  than  single-name  paper  ;  but  such  paper 
is  no  longer  obtainable  in  quantities.  In  the  present 
case  the  item  is  considered  a  good  asset. 

Item  D,  covering  bills  receivable  due  from  branches, 
must  be  thrown  out.  Since  the  branches  are  parts  of 
the  main  house  their  obligations  are  also  obligations  of 
the  main  house,  and  cannot  in  any  way  be  called  assets. 
The  confusion  sometimes  brought  into  the  matter  of 
the  relations  between  parent  houses  and  their  branches, 
or  between  the  home  office  of  a  corporation  and  its  sub- 
sidiary offices,  is  cleared  up  when  we  remember  that  for 
the  general  purpose  of  estimating  upon  the  financial 
value  of  shares  and.  bonds,  the  branches  and  the  head 
office  constitute  but  one  concern.  If  juggling  with 
figures  or  technical  book  keeping  operations  is  indulged 
in,  it  is  usually  done  to  conceal  annual  losses  or  de- 
preciation or  else  to  make  the  reported  condition  seem 
better  than  the  reality.     In.  small  trading  companies 


Corporation  Accounting  93 

the  matter  is  usually  more  simple.  Instances  have 
been  known  where  the  head  office,  ignoring  the  real 
position  of  its  branches,  has  asked  for  bills  payable  to 
cover  only  the  book  keeping  debts  due  to  the  parent 
company.  These  bills  in  the  names  of  the  branch  were 
endorsed  by  the  manager  and  discounted  at  the  bank, 
the  proceeds,  of  course,  making  a  surprisingly  excellent 
showing  in  the  annual  statement.  The  indorsed  bills 
were  not  included  among  the  liabilities  because  not 
considered  * '  direct ' '  obligations.  Of  course,  the  ex- 
hibit thus  made  was  not  a  correct  statement  of  the 
company's  real  condition.  Many  trading  firms  and 
corporations  habitually  exclude  from  their  public  an- 
nouncement all  indirect  obligations  of  endorsement  on 
the  ground  that  they  become  a  proper  charge  only 
when  not  paid  by  the  maker.  This  is  true  so  far  as 
the  sheet  itself  is  concerned,  but  the  share-  or  bond- 
holder who  wishes  to  learn  all  the  facts  should  know  by 
a  separate  statement  how  large  these  indirect  endorsed 
obligations  are.  If  out  of  proportion,  it  then  becomes 
important  to  inquire  why  they  exist,  and  how  far  the 
makers  are  financially  responsible.  The  matter  of 
indirect  debts  which  may  become  direct,  is  one  which 
should  have  careful  consideration  in  all  corporation 
management.  A  manager  willing  to  take  advantage 
of  book  keeping  technicalities  may  not  speak  of  con- 
tracts which  he  has  made  for  the  purchase  of  supplies 
or  machinery  because  dated  ahead,  and  therefore  not 
yet  direct  obligations  ;  but  all  such  prospective  debts 
must  be  known  if  a  clear  view  of  the  future  is  desired. 
The  Blank  Trading  Company  acknowledge  that  they 
have  a  contingent  liability  amounting  to  $20,000. 

Item  E,  accounts  of  customers,  is  a  most  important 
one  in  a  trading  company's,  statement,  and  one  equally 


94  Corporation  Finance 

hard  to  value.  Book  accounts  and  merchandise  are 
the  main  assets  of  firms  and  corporations  doing  a  trad- 
ing business.  If,  upon  investigation,  it  is  found  that 
these  two  items  can  be  considered  really  good  assets, 
the  company  is  justified  in  expecting  credit.  The  first 
question  to  ask  concerning  accounts  receivable  is  :  Are 
they  in  proportion  to  the  amount  of  business  done  and 
not  in  excess  of  the  proportion  of  the  same  item  among 
other  houses  in  the  same  trade  ?  In  some  trades  these 
book  accounts  run  fairly  uniform  throughout  the  year. 
In  others  they  vary  so  as  to  show  large  amounts  at  one 
season  with  small  sums  at  another  ;  in  the  latter  case 
one  may  judge  of  the  item  partly  by  the  date  of  the 
statement.  In  the  particular  line  of  trade  which  has 
been  chosen  for  our  illustration  the  amount  of  accounts 
receivable  on  the  last  day  of  the  calendar  year  ought  to 
be  quite  small,  increasing  in  amount  from  the  first  of 
the  year  until  the  conditions  are  reversed  by  spring  or 
early  summer.  Perhaps  ten  per  cent,  of  the  gross 
aggregate  sales  would  be  a  fair  proportion  to  expect  for 
this  item  in  the  statement  under  our  assumed  condi- 
tions. It  will  be  noticed  that  this  item  is,  therefore, 
about  twice  what  it  ought  to  be.  This  fact  of  itself 
furnishes  a  reason  for  further  investigation.  It  is, 
of  course,  possible,  that  these  accounts  are  all  good 
— possible,  but  not  probable.  One  might  inquire 
how  much  of  these  book  accounts  is  over-due  and  is 
carried  along  by  the  company.  If  the  proportion 
of  over-due  accounts  in  this  item  is  at  all  heavy,  it  is 
an  indication  either  that  goods  have  been  too  freely 
sold  to  irresponsible  parties  on  credit,  or  else  that  some 
misfortune,  such  as  the  loss  of  a  staple  crop,  has  fallen 
upon  a  certain  section  of  the  community  in  which  a 
large  quantity  of  The  Blank  Trading  Company's  goods 


Corporation  Accounting  95 

have  been  sold  ;  a  possibility  always  to  be  borne  in 
mind  when  inquiring  whether  the  credit  risks  are  scat- 
tered or  practically  confined  to  one  or  two  sections  of 
the  country  ;  to  be  sure  not  to  be  caught  by  any  tech- 
nical differences,  one  should  ask  how  many  of  these 
accounts  have  been  extended  when  due,  which,  of 
course,  is  another  way  of  carrying  them.  If  the  com- 
pany will  make  up  a  statement  of  the  customers  who 
are  indebted,  one  may  obtain  their  rating  from  a  mer- 
cantile agency  and  see  what  the  proportion  is  between 
their  capitals  as  thus  reported  and  the  obligations  in 
question.  If  a  large  part  of  these  obligations  figure 
out  to  be  more  than  twenty-five  per  cent,  of  the  capital 
of  these  customers,  one  may  distrust  the  value  of  their 
accounts.  In  the  present  case,  it  is  stated  that  the 
president  of  the  company  is  interested  in  a  retail  store 
to  whom  the  company  sells  goods.  Technically  we 
may  expect  that  the  company  would  not  consider  the 
account  of  this  retail  store  as  over-due,  and  yet  it  is 
possible  that  the  swelling  of  this  item  beyond  the  limits 
customary  in  that  particular  line  of  trade  may  be  owing 
to  the  credits  granted  to  this  particular  store.  Perhaps 
it  is  fotmd  that  suspicions  are  in  part  confirmed,  and 
that  the  excess  of  book  accounts  over  the  normal 
amount  is  really  dead-wood  carried  by  the  company. 
One,  therefore,  in  his  estimate  of  values,  may  put  down 
this  item  at  about  $30,000. 

Item  G,  merchandise.  It  is  so  easy  to  accumulate 
old  and  unsalable  merchandise  that  nothing  but  eternal 
vigilance  can  keep  a  firm  free  from  that  error.  It  is 
very  difficult  for  the  ordinary  investigator  to  make  up 
his  mind  regarding  this  item  in  the  company's  state- 
ments ;  so  much  depends  upon  the  business  instinct 
with  which  the  goods  are  selected  and  the  judgment 


96  Corporation  Finance 

with  which  the  future  of  the  particular  trade  is  fore- 
casted. Another  matter  that  one  should  know  is,  on 
what  basis  the  value  of  the  goods  has  been  arrived  at. 
In  our  table  it  is  stated  that  the  merchandise  is  ' '  val- 
ued at  cost,"  meaning  cost  to  The  Blank  Trading 
Company.  In  these  figures,  therefore,  is  included  the 
manufacturer's  profit,  which  again  is  afiected  by  the 
credit  of  the  purchasing  company.  The  open  accounts 
due  by  this  corporation  are  fairly  heavy,  and  one  may 
reasonably  conclude  that  the  merchandise  has  not  been 
reduced  in  cost  by  any  discounts  for  cash.  In  short,  it 
is  proper  to  refuse  to  accept  this  item  at  its  face  value 
in  estimation  on  the  solvency  of  the  company. 

In  judging  of  a  firm's  or  corporation's  solvency  the 
character  of  the  goods  dealt  in  must  always  be  borne  in 
mind.  The  difference  between  staple  and  fancy  goods 
is  one  which  not  only  distinguishes  one  trade  from  an- 
other but  is  an  important  distinction  many  times  to  be 
drawn  between  a  certain  set  of  articles  and  another  in 
the  same  store.  Groceries  may  be  accepted  at  almost 
full  value  even  under  the  hammer,  while  silks  and  rib- 
bons are  dependent  upon  the  caprices  of  fashion  from 
one  season  to  another.  In  like  manner  hardware  can 
be  taken  at  a  close  estimate  nearer  to  its  inventory 
value  than  can  boots  and  shoes.  Wool  is  a  more  stable 
article  than  woollens  ;  and  so  we  might  go  through  the 
list.  In  the  present  instance  it  is  proper  to  say  that 
fancy  goods  are  of  uncertain  value,  yet  one  may  assume 
that  The  Blank  Trading  Company  deals  in  the  more 
stable  kinds.  Nevertheless,  it  is  clear  that  one  cannot 
assume  the  full  value  for  the  stock  of  merchandise  in 
question  if  sold  at  auction.  Balancing  all  these  proba- 
bilities, the  value  of  this  item  may  be  fixed  at  $100,000. 

The  proper  valuation  to  be  put  upon  book  accoimts 


Corporation  Accounting  97 

and  merchandise  in  cases  of  insolvency  are  constant 
subjects  of  study  among  those  whose  business  it  is  to 
loan  money  to  firms  or  companies  either  by  direct  dis- 
count or  through  purchase  of  commercial  paper.  Below 
is  a  table  of  liquidating  values  for  five  trades,  compiled 
by  a  banker  of  experience  : 


Trades 

Accounts  Receivable 
percentage  good 

Merchandise 
percentage  good 

Hardware 

72 

80 

Dry  Goods 

67 

70 

Boots  and  Shoes 

80 

65 

Furniture 

70 

68 

Groceries 

40 

95 

The  experience  of  different  bankers  and  of  different 
trading  firms  and  companies  may  be  more  favorable  or 
unfavorable  than  this  table  indicates  regarding  the 
realizable  value  of  book  accounts  and  stocks  of  mer- 
chandise. It  should,  therefore,  be  modified  in  accord- 
ance with  the  business  reputation  of  the  men  in  charge, 
or  of  the  traders  in  the  particular  section  to  whom  the 
goods  have  been  sold  on  credit. 

Item  H,  real  estate,  $27,000.  This  value  seems  a 
little  high  for  the  comparatively  small  amount  of  busi- 
ness done,  and  should  have  further  investigation. 
Some  small  companies,  sometimes  through  carelessness 
rather  than  actual  error,  add  the  cost  of  improvements 
made  from  year  to  year  to  the  value  of  their  real  estate 
until  this  item  comes  to  stand  on  their  books  at  an 
amount  much  in  excess  of  its  actual  selling  worth.  In 
the  present  instance,  it  is  assumed  that  this  has  been 
the  practice,  and  that  the  actual  value  of  the  property 
by  appraisal  is  $15,000. 

Item  J,  machinery  and  fixtures,  is  a  small  one  in 


98  Corporation  Finance 

any  case  and  need  not  be  commented  upon.  If  it  were 
an  important  item,  one  should  inquire  as  to  the  de- 
preciation. 

Item  K,  merchandise  in  bonded  warehouses,  $37,600, 
is  subject  to  the  same  criticism  as  regards  its  real  value 
as  that  already  passed  upon  the  merchandise  in  stock  ; 
that  is,  for  the  purpose  of  questioning  the  solvency  of 
the  company  or  of  putting  a  value  upon  its  preferred  or 
common  shares  the  figures  named  in  the  statement  are 
too  high.  In  addition  to  this,  it  is  noted  in  the  business 
statement  that  a  part  of  this  bonded  merchandise  is 
subject  to  trust  receipts. 

It  is  a  common  practice  for  firms  doing  an  importing 
business  to  have  the  foreign  goods  consigned  to  a  New 
York  City  banking  house,  upon  whom  also  the  foreign 
bills  are  drawn  payable  in  a  certain  number  of  days, 
varying  according  to  the  customs  of  the  different  coun- 
tries. It  frequently  happens  that  these  goods  reach 
their  destination  before  the  bills  drawn  against  them 
are  due.  In  order  that  the  merchandise  may  be  sold 
by  the  importing  firm  soon  after  arrival,  an  arrange- 
ment to  this  effect  is  made  through  trust  receipts. 
One  form  of  such  receipts  gives  the  importing  house 
possession  of  the  goods,  but  without  title,  the  house  or 
corporation  guaranteeing  to  hand  the  proceeds  of  the 
sale  over  to  the  banking  house.  Another  form  permits 
the  putting  of  the  goods  in  store  under  warehouse 
receipts.  These  forms  are  varied  according  to  the  cir- 
cumstances of  the  case  and  the  credit  and  standing  of 
the  importing  companwbut  in  whatever  way  the  busi- 
ness is  transacted,  theJneaning  is  that  the  merchandise 
affected  is  not  the  property  of  the  importing  house, 
and  cannot,  therefore,  be  included  in  its  list  of  assets. 
In  the  present  case,  something  must  be  deducted  from 


I 


Corporation  Accounting  99 

this  face  value  on  this  account  also.     It  will  be  dealing 
generously  with  this  item  if  it  is  put  down  at  $20,000. 

By  adding  up  the  assets  as  re- valued,  we  find  the 
total  to  be  $177,400.  A  glance  at  the  table  of  liabil- 
ities shows  a  total  of  $320,000.  If  from  this  one  deducts 
for  his  own  purpose  capital  stock  and  the  profit  and 
loss — the  latter  item  being  simply  to  balance  accounts, 
— he  finds  the  actual  debts  for  money  to  amount  to 
$185,000,  or  about  $8000  more  than  the  assets  as  valued 
in  our  examination.  This  means,  in  efiect,  that  if  the 
company  should  be  wound  up,  the  holders  of  both  pre- 
ferred and  common  stock  would  lose  their  whole  invest-  j  , 
ment  and  very  likely  some  of  the  creditors  also  would  I  i 
not  be  paid  in  full.  Although  according  to  the  state-/ ' 
ments  this  trading  company  paid  dividends  last  year 
amounting  to  eight  per  cent,  upon  the  preferred  and 
twelve  per  cent,  upon  the  common  shares,  yet  it  is 
clear  that  no  dividends  ought  to  have  been  distributed 
until  a  fund  had  been  accumulated  which  would  bal- 
ance the  possible  bad  debts  and  depreciation  of  mer- 
chandise of  which  we  have  spoken. 

The  sales  are  stated  to  have  amounted  the  preceding 
year  to  $350,000.  This,  it  will  be  noted,  is  only  3>^  \ 
times  the  capital.  There  has  been  some  gross  misman- 
agement of  the  business  because  modern  conditions 
demand  that  the  capital  should  be  turned  over  many 
more  times  than  this  during  the  year.  This  impression 
is  confirmed  when  we  look  at  the  amount  of  business 
expenses,  $60,000.  Taking  the  expenses  and  dividends 
together,  it  will  be  noticed  t%t  it  required  twenty  per 
cent,  profits  on  the  small  amoimt  of  sales  to  meet  them. 
Few  business  houses  in  these  d^s  of  sharp  competition 
can  be  assured  of  the  continuance  of  so  large  an  aver- 
age gross  profit  as  that  at  wholesale.    There  is  dearly 


lOO  Corporation  Finance 

something  the  matter  with  the  affairs  of  the  company. 
It  is  possible  that  some  of  the  excess  in  accounts  receiv- 
able already  spoken  of  represents  bad  debts  contracted 
by  the  company  in  order  to  cover  so  large  an  amount 
of  business  expenses.  To  secure  so  large  a  percentage 
of  profit  they  have  been  willing  to  sell  goods  to  retail 
houses  with  indifferent  credit.  If  these  bad  debts  had 
been  charged  off  there  would  have  been  no  dividends 
and  it  might  have  been  found  that  expenses  had  not 
been  earned. 

Although  the  valuation  put  on  the  assets  shows  that 
at  forced  sale  they  would  only  realize  enough  to  pay 
the  creditors,  it  does  not  follow  that  the  affairs  of  the 
company  cannot  be  retrieved.  There  is  a  foundation 
here  for  better  Dusiness.  If  energy  and  ability  can  be 
secured,  in  the  management,  the  amount  of  sales  can 
be  doubled  and  expenses  reduced  so  as  to  show  a  great 
change  in  the  proportion  to  the  volume  of  trade.  If  for 
a  while  the  profits  thus  realized  could  be  applied  to  the 
reduction  of  the  uncertain  items  among  the  assets,  it  is 
possible  that  in  a  few  years  the  aspect  of  things  could 
be  so  completely  changed  as  to  show  that  the  company 
was  again  in  a  sound  condition. 

Complete  change  in  the  modem  methods  of  supply- 
ing mercantile  credits  makes  it  necessary  for  the  lender 
of  money  whether  on  commercial  paper  or  in  the  form 
of  bonds  or  of  preferred  shares,  to  rely  upon  the  general 
solvency  of  the  firm  or  corporation.  This  of  itself 
makes  needful  a  more  or  less  thorough  investigation 
into  the  whole  affairs  of  the  borrowing  houses.  Very 
likely  in  this  matter  as  in  other  lines  of  business  there 
will  arise  banks  and  banking  houses  which  will  make 
a  specialty  of  such  loans. 

The  same  set  of  facts  puts  a  new  responsibility  upon 


Corporation  Accounting  loi 

the  firms  and  companies  which  ask  for  credit.  These 
requests  for  loans  involve  two  things  :  first,  that  the 
borrowers  are  honest  and  mean  to  pay — ^which,  in  the 
majority  of  cases,  is  taken  for  granted, — and  second, 
that  there  is  a  reasonable  hope  of  their  ability  to  pay. 
This  latter  point  does  not  concern  the  honesty  of  the 
managers,  but  depends  for  its  answer  upon  a  wide  esti- 
mate of  business  facts.  It  is,  therefore,  no  reflection 
upon  a  borrowing  firm  or  company  to  have  the  investor 
or  lender  ask  for  such  a  statement  of  their  affairs  as 
shall  enable  him  to  form  a  business  judgment  upon 
their  condition.  The  asking  for  investment  money  on 
mercantile  loans  from  banker  or  investor  implies,  there- 
fore, that  such  a  statement  shall  be  forthcoming. 

The  habit  of  making  such  statements  for  more  or  less 
public  examination  will  cause  the  managers  to  give 
even  closer  attention  to  the  meaning  of  various  items 
which  they  are  carrying  upon  their  books.  In  this  way 
conservatism  is  increased  by  the  conditions  of  doing 
business,  which  now  demand,  on  the  one  side,  large 
loans  of  capital,  and,  on  the  other,  business  ability  and 
honesty  without  sentimentalism. 


CHAPTER  VI 

TH^  E)XAMINATlON  OF  RAII^WAY  REPORTS 

THE  bonds  and  shares  of  the  railways  of  the  United 
States  form  the  most  available  investments  or 
instruments  of  speculation  for  the  people.  The  general 
knowledge  about  railways  is  greater  and  the  industry 
itself  more  firmly  established  than  is  the  case  with 
other  large  enterprises.  The  securities  of  these  rail- 
ways are  the  ones  most  prominently  dealt  in  upon  our 
exchanges,  thus  giving  to  holders  the  important  advan- 
tages of  easy  and  quick  purchases  or  sales.  For  these 
reasons  it  is  advisable  that  the  items  which  are  con- 
tained in  the  usual  annual  reports  should  be  analyzed 
at  length  and  in  detail,  in  order  that  any  purchaser  or 
holder  may  be  able  to  form  for  himself  a  general  idea 
of  the  meaning  of  railway  statistics  and  of  the  import- 
ance of  the  differences  appearing  in  those  reports  from 
year  to  year. 

The  Great  Eastern  Railway  is  a  supposititious  road  in 
the  United  States  east  of  the  Missouri  River.  Having 
no  actual  existence,  its  supposed  records  can,  without 
invidious  comparisons,  be  made  the  text  of  an  examin- 
ation into  the  meaning  of  railway  statistics,  and  the 
relation  of  one  item  to  another  in  such  tables  as  are 
usually  printed  in  railway  annual  reports. 

Although   paying   four  per  cent,    dividends,    it   isj 
assumed  that  the  stock  of  the  Great  Eastern  Railway  j 

I02 


The  Examination  of  Railway  Reports     103 

is  not  quoted  at  very  high  prices  on  the  exchanges.  A 
company  which  is  really  earning  four  per  cent.,  and 
which  seems  likely  to  continue  earning  and  paying 
that  dividend,  usually  finds  its  stock  well  thought  of  in 
financial  circles.  Contrary  to  this  rule,  a  holder  of 
Great  Eastern  shares  sees  his  stock  declining  under 
daily  sales  presumably  by  * '  insiders. ' '  Naturally  his 
attention  is  aroused  ;  he  asks  himself  why  the  prices 
of  his  shares  should  fall ;  in  search  of  information 
which  should  satisfy  his  questionings,  he  first  takes  up 
the  annual  report  of  his  railway  and  looks  over  the 
figures  given  therein.  On  the  first  pages  he  finds  an 
income  account  for  the  last  fiscal  year,  containing 
nothing  which  on  the  face  of  it  could  be  construed 
unfavorably.  The  statement  of  the  result  of  the  year 
is  as  follows : 

GRKAT  EASTERN  RAII^WAY  :   INCOME  ACCOUNT 

To  JUNE  30 

Gross  earnings  ;    passenger |i,o8o  cxo 

freight 5,6oo  ooo 

^  mail  and  express 120  000 

Total 6,800000 

Operating  expenses  (62  per  cent.) 4,200  000 

Net  earnings 2,600  000 

Add  interest  on  bonds  owned 250  000 

Gross  income 2,850  000 

Fixed  charges  :   taxes %\qo  000  • 

bond  interest 1,300  000  1,400  000 

Net  income 1,450  000 

Dividends  at  four  per  cent 1,200  000 

Surplus  for  the  year,  carried  to  profit  and  loss 250  000 


I04  Corporation  Finance 

On  succeeding  pages  of  the  annual  report  are  given 
the  results  for  the  year  of  the  Rich  Valley  Railroad,  a 
branch  or  feeding  line,  owned  by  the  Great  Eastern 
Company,  but  operated  independently  : 

Gross  earnings |i>5oo  ooo 

Operating  expenses 1,400  000 

Net  earnings 100  000 

Guaranteed  bond  interest  paid 700  000 

Deficit  for  the  year 600  000 

There  is  nothing  which  necessarily  shows  bad  man- 
agement in  the  fact  that  a  ''feeder''  is  not  self-sup- 
porting. The  Rich  Valley,  as  its  name  implies,  may 
be  a  short  line  running  through  a  rich  agricultural 
and  manufacturing  district,  the  greater  part  of  whose 
traffic  is  carried  by  the  parent  road  to  the  great  mar- 
kets. Were  it  not  for  this  branch  the  traffic  would 
seek  a  rival  road.  Hence  in  this  case  the  profits  result- 
ing from  the  carriage  of  this  extra  business  are  worth 
to  the  Great  Eastern  Railway,  it  is  assumed,  a  great 
deal  more  than  the  $600,000  which  it  loses  through  its 
guaranty  of  Rich  Valley  bonds.  The  policy  of  build- 
ing or  purchasing  branch  lines  which  are  run  at  a  loss 
may,  of  course,  be  carried  to  such  an  extreme  as  to 
involve  the  guaranteeing  company  ;  particularly  when 
the  real  effect  of  such  annual  losses  is  concealed  by  the 
method  of  book-keeping  adopted  in  this  case.  Clearly 
the  Great  Eastern  Company  must  pay  this  deficit  of 
$600,000  ;  but  from  what  fund  ?  Since  the  gross  and 
net  earnings  of  the  main  line  receive  all  the  benefit  of 
the  traffic  turned  over  to  it  by  the  branch,  and  since,  as 
we  have  asstuned,  this  benefit  is  great,  it  follows  that 
the  cost  of  procuring  that  extra  traffic  is  a  proper 


The  Examination  of  Railway  Reports     105 

charge  against  the  income  helped  thereby.  In  other 
words,  the  annual  loss  of  $600,000  on  the  branch  line, 
unless  clearly  but  a  temporary  deficit,  ought  to  be 
deducted  from  the  gross  income  of  the  Great  Eastern 
Railway  before  a  dividend  is  declared.  If  this  is  not 
done — and  a  glance  back  at  the  income  account  pre- 
sented shows  no  mention  of  the  item, — the  real  earning 
power  of  the  company  is  to  that  extent  overstated  and 
the  dividend  unjustifiable. 

How,  then,  is  the  deficit  of  the  Rich  Valley  branch 
carried  ?  To  answer  this  question  the  general  balance- 
sheets  for  two  years  must  be  examined.  These  gen- 
eral balances  show  on  the  one  side  the  assets  of  the 
company  and  on  the  other  the  liabilities.  The  different 
amounts  are  stated  at  their  face  and  not  at  their  intrin- 
sic values.  Ordinarily  it  is  useless  labor  to  go  through 
a  company's  general  balances  for  the  sake  of  getting  at 
the  actual  worth  of  the  properties.  Hence,  for  the 
information  of  ordinary  shareholders,  the  most  import- 
ant object  in  having  general  balance  accounts  is  the 
opportunity  afforded  for  annual  comparison.  If  we 
note  the  changes  in  the  items  from  one  year  to  another, 
we  can  often  get  valuable  hints  about  the  real  pros- 
perity of  the  company,  because  the  facts  thus  revealed 
may  not  be  mentioned  in  the  text  of  the  annual  report. 
First,  then,  should  be  stated  the  balance-sheet  for  two 
years : 


io6 


Corporation  Finance 


GRKAT   EASTE^RN    RAII^WAY 
GENKRAI,  BAlvANCE-SHKKT,  JUNE  30,  PREVIOUS  YEAR 


Assets 

I^iabilities 

Cost  of  road 

|45,ooo  000 

Capital  stock 

$30,000  000 

Cost  of  equipment 

10,000  000 

Funded  debt  (5  %), 

25,000  000 

Stocks      owned, 

Interest  accrued. . 

500  000 

Rich  Valley  Co. 

1,000  000 

Due      connecting 

Five  per  cent. 

roads  

600  000 

bonds  of  Rich 

Due  for  wages 

500  000 

Valley    branch 

Supply     accounts 

owned 

5,000  000 

payable 

Claim  vouchers 

100  000 

Advances  to  Rich. 

Valley 

400  000 

audited 

100  000 

Due  from  connect- 

Profit and  loss. . . . 

5,500  000 

ing  roads 

250  000 

Materials  on  hand, 

200  000 

Accounts     receiv- 

able   

100  000 

Suspense  accounts 

100  000 

Cash  on  hand. . . . 

250  000 

162,300  000 

{62,300  000 

GREAT   EASTERN   RAII^WAY 

GENERAI,  BAI,ANCE-SHEET   JUNE  30,    PRESENT  FISCAI,   YEAR 

(Corresponding  to  the  income  account  given  above.) 


Cost  of  road 

^48,000 

000 

Capital  stock 

$30,000  000 

Cost  of  equipment 

11,000 

000 

Funded  debt  (5  ^). 

27,000  000 

Stocks    owned, 

Interest  accrued. . 

700  000 

Rich     Valley 

Due      connecting 

branch 

1,000 

000 

roads  

1,000  000 

Bonds  owned 

5,000 

000 

Due  for  wages 

700  000 

Advances  to  Rich 

Accounts  payable, 

300  000 

Valley. 

1,000 

000 

Bills  payable 

1,000  000 

Due  from  connect- 

Supply    accounts 

ing  roads  

200 

000 

payable 

300  000 

Materials  on  hand 

150 

000 

Claim       vouchers 

Accounts    receiv- 

audited  

200  000 

able  

300 

000 

Profit  and  loss 

5,750  000 

Suspense  accounts 

200 

000 

Cash      and     cash 

items 

100 

000 

|66,950  000 

«fc                         — 

J66,95o 

000 

The  Examination  of  Railway  Reports     107 

A  brief  explanation  of  the  items  first  may  be  desir- 
able. The  costs  of  road  and  equipment  are  approxi- 
mate statements  of  the  amount  of  money  spent  for  these 
objects,  though  they  contain  items  which  are  only  in- 
directly a  charge  against  cost.  For  example,  in  those 
balance-sheets  will  be  noticed  an  increase  of  bonds  from 
$25,000,000  to  $27,000,000  during  the  year.  If  these 
bonds  were  sold  at  a  discount,  say  twenty  per  cent., 
the  amount  so  deducted  from  their  face  value,  $400,000, 
would  not  represent  mojiey  put  into  the  road  directly 
or  physically,  though  the  whole  increase,  $2,000,000,  it 
will  be  noticed,  is  added  to  cost  of  road  in  another  way, 
/.  e. ,  in  its  lack  of  credit.  Sometimes  this  item  of  bond 
discount  does  not  arise  from  lack  of  credit  but  from  an 
attempt  to  issue  bonds  at  a  rate  of  interest  so  low,  com- 
pared with  the  ruling  rate  in  the  money  market,  that 
par  cannot  be  obtained  for  the  bonds.  In  such  cases, 
since  the  income  account  presumably  is  benefited  by 
the  small  annual  interest  charges,  that  same  income 
account  should  be  debited  each  year  with  a  proportion 
of  the  loss  by  the  discount.  The  item  profit  and  loss 
has  misled  many.  If  the  assets  foot  up  more  than  the 
liabilities  (and  every  road  tries  to  have  it  so,  even  as  a 
matter  of  book-keeping,  for  appearance's  sake),  the 
item  appears  on  the  liability  of  the  account.  It  will 
thus  be  seen  to  be  what  it  really  is,  merely  the  balance 
between  the  assets  and  liabilities  in  the  general  balance- 
sheet  representing  the  supposed  excess  of  property  over 
the  capitalization  and  debts.  It  is  not  money  in  hand  : 
it  usually  covers  former  annual  surpluses  which  may 
long  ago  have  been  spent  for  equipment  or  on  road,  or 
invested  in  the  materials  carried  in  the  storehouses  and 
not  yet  put  into  the  property.  If  a  road  has  cash 
or  salable  securities  in  unusual  measure,   these  will 


io8  Corporation  Finance 

be  found  on  the  opposite  side  of  the  accounts  as 
assets. 

Another  item  is  the  interest  accrued  but  not  due. 
Such  accrued  interest  should  always  be  put  down  as  a 
liability  in  balance-sheets,  otherwise  an  unreal  pros- 
perity would  be  shown  at  one  time  or  an  unreal  depres- 
sion at  another,  according  as  the  bond  interest  becomes 
payable.  In  all  railway  tables  there  are  found  items 
of  current  accounts  with  connecting  roads  both  debit 
and  credit,  cost  of  materials  and  supplies  purchased 
but  not  yet  used  or  charged  to  the  respective  operating 
departments,  and  the  like,  being  things  for  which 
working  capital  must  be  provided.  Two  further  items 
in  our  statements  merit  notice.  Supply  bills  payable 
is  one.  Every  report  should  be  examined  to  see 
whether  this  liability  is  included.  It  is  the  custom  for 
all  large  companies  to  buy  their  fuel,  rails,  ties,  etc., 
on  time.  Hence  every  company  on  any  particular  date 
has  a  large  amount  of  obligations  out,  which  are  not  yet 
due  and  for  which  no  notes  have  been  issued. "  Tech- 
nically these  may  not  be  considered  in  the  balance- 
sheets  until  due,  but  since  they  are  sure  to  become  due 
shortly,  there  can  be  no  true  statement  of  the  com- 
pany's condition  made  without  including  them.  Some- 
times when  engines  and  cars  have  just  been  purchased, 
these  unrecorded  obligations  may  be  very  heavy. 
Again,  when  in  straits  for  money,  railway  companies 
do  not  hesitate  to  pigeon-hole  the  bills  for  supplies  sent 
them  until  the  accumulated  debts  become  large  ;  and, 
if  not  stated  in  the  balance-sheets,  an  untrue  appear- 
ance of  ease  in  money  matters  is  given. 

Audited  vouchers  often  form  a  growing  obligation 
when  traffic  is  depressed.  Claims  for  losses  of  goods 
and  rebates  (not  always  unfair)  are  common  ;  in  spite 


The  Examination  of  Railway  Reports     109 

of  care,  overcharges  in  the  freight  bills  rendered  con- 
signees will  be  made  through  the  errors  of  clerks  ; 
wrecks  may  destroy  much  property  for  which  the  com- 
pany is  responsible  ;  cattle  may  be  hurt  by  trains  ;  and, 
worst  of  all,  accidents  may  kill  or  maim  passengers. 
The  claims  thus  presented  to  the  company  are  often 
very  large  in  amount.  After  investigation  a  certain 
portion  are  pronounced  true  claims  and  marked  for 
payment.  Such  items  are  called  ''  audited  claims  or 
vouchers  ^ '  and  should  find  a  place  in  every  balance- 
sheet.  The  still  larger  amounts  of  claims  for  losses, 
overcharges,  or  rebates  not  yet  passed  upon  cannot  well 
be  stated  in  the  balance-sheet,  because  their  amount  is 
uncertain,  yet  when  ''  cut  rates  "  are  freely  given  the 
aggregate  of  claims  and  rebates  which  must  presum- 
ably one  day  be  paid  may  be  so  great  that  the  amount, 
if  known,  would  make  a  serious  impression.  Yet,  on 
the  other  hand,  where  the  sum  of  such  unaudited 
claims  stays  approximately  the  same  from  year  to  year, 
no  real  harm  is  done  by  not  attempting  to  include  them 
in  the  company's  tables. 

Among  the  assets  the  items  *'  accounts  receivable  '* 
and  '  ^  suspense  accounts ' '  require  little  explanation. 
These  are  claims  carried  by  the  company  against  othej 
roads  or  against  merchants.  They  may  be  good  or 
they  may  not.  Every  company  should  have  a  separate 
table  of  Profit  and  lyoss,"  to  which  all  such  doubtful 
credits  should  be  charged.  It  may  be  technically  cor- 
rect book-keeping  to  keep  uncollectible  accounts  stand- 
ing among  the  assets  of  the  general  balance-sheet,  but 
no  matter  how  the  rules  of  book-keeping  treatises  may 
read,  the  object  of  all  corporation  accounting  is  to 
represent  the  commercial  facts. 

Companies  which  hesitate  to  deduct  losses  (branch- 


no  Corporation  Finance 

line  losses  included)  from  their  income  account  and  yet 
shrink  from  actually  calling  such  losses  *  *  assets ' '  should 
charge  such  deferred  claims  to  "'  Profit  and  lyoss/' 
crediting  that  account  with  the  annual  surpluses  from 
operation.  The  difference  would  then  show  the  real 
earnings.  If  at  any  time  such  old  claims  should  be- 
come collectible,  the  same  account  could  be  credited 
with  the  sums  thus  recovered. 

The  array  of  figures  in  our  general  balance-sheets 
looks  a  little  bewildering  ;  so  to  make  the  matter 
clearer,  we  will  tabulate  the  changes  during  the  year  : 

KXPKNDITURKS  : 
FOR  WHAT  PURPOSE  INCURRED 

Increase  in  cost  of  road |3,ooo  coo 

"        **  cost  of  equipment 1,000000 

"         **  advances  to  Rich  Valley 600  000 

"        **  accounts  receivable 200  000 

"        "  suspense  accounts 100  000 

$4,900  000 
RESOURCES  : 

WHENCE   DERIVED 

Decrease  in  amounts  due  from  connecting  roads. ..  50  000 

**         "   material  on  hand 50000 

**        "   cash  and  cash  items 150  000 

Increase  in  funded  debt 2,000  000 

**        "  interest  due 200  000 

"        "  amounts  due  connecting  roads 400  000 

**        *'   wages  due 200  oocf 

"        "  unadjusted  accounts 300  000'* 

"         **  bills  payable 1,000  000 

"        "  supply  accounts  due 200  000 

**         "  vouchers  audited 100  000 

**        "  profit  and  loss 250000 

14,900  000 


The  Examination  of  Railway  Reports     1 1 1 

This  summary  of  changes  in  the  position  of  the 
company  dnring  the  year  is  worth  study.  The  words 
*' expenditures"  and  ''resources"  are  used  in  their 
book-keeping  sense  :  a  decrease  in  the  amount  due 
fro7n  other  roads  and  an  increase  in  the  amount  due  to 
other  roads  being  both  aUke  resources  for  our  present 
purpose.  The  statement  shows  an  increase  in  invest- 
ment in  road  and  equipment  amounting  to  $4,000,000, 
of  which  more  hereafter.  The  deficit  of  the  Rich  Val- 
ley branch  is  seen  to  have  been  carried  in  the  accounts 
also  as  an  increase  in  value  of  plant,  ofiset  on  the  other 
side  of  the  account  by  money  newly  borrowed.  We 
are  assuming  that  this  is  not  a  correct  principle  and 
that  the  value  of  the  property  has  not  been  advanced  a 
penny  through  the  Rich  Valley,  since  all  the  profit  for 
the  branch  for  the  year  has  already  been  included  in 
Great  Eastern  earnings.  This  system  of  disposing  of 
branch-line  losses  in  the  accounts  is  resorted  to  mainly 
to  allow  of  borrowing  money  to  meet  the  deficiency. 
Carrying  subsidiary  losses  as  assets  and  borrowing 
money  or  issuing  bonds  therefor,  has  been  a  common 
practice.  The  combination  of  many  small  roads  into  a 
large  system  permits  such  accounting,  either  through 
mistakes,  optimism,  or  for  purposes  of  deception,  with- 
out danger  of  detection  by  superficial  examination. 
Sometimes  this  way  of  concealing  deficits  is  practised 
for  a  year  or  two  during  hard  times,  the  officers  intend- 
ing to  apply  the  surplus  revenues  of  succeeding  pros- 
perous years  toward  wiping  out  all  these  imaginary 
assets  and  the  debts  contracted  to  pay  for  them.  Such 
a  policy  should  be  leniently  judged,  if  honestly  held. 
Of  course  it  is  also  proper  to  treat  in  this  way  a  genu- 
ine loan  when  repayment  is  reasonably  certain.  The 
balance-sheets  further  show  that  the  only  bonds  owned 


112  Corporation  Finance 

by  the  Great  Eastern  Railway  are  those  of  the  Rich 
Valley  branch.  A  glance  at  the  income  account 
shows  $250,000  received  from  this  source.  It  thus 
appears  that  in  order  to  show  that  dividends  had  been 
earned,  the  directors  of  the  Great  Eastern  Company 
did  not  charge  up  the  losses  of  the  Rich  Valley  branch 
as  they  should  have  done,  but  did  take  credit  to  them- 
selves for  $250,000  unearned  interest  on  their  own 
guaranteed  bonds. 

We  now  begin  to  grow  suspicious  and  scrutinize  the 
items  more  closely.  The  bonded  debt  and  the  bills 
payable  amount  to  $28,000,000,  for  which  interest  at 
but  five  per  cent,  on  the  total  (and  money  is  not 
always  borrowed  **  in  the  street ''  at  as  low  a  rate  as 
that)  would  amount  to  $1,400,000  per  year,  whereas 
but  $1,300,000  is  allowed  in  the  income  account.  This 
may  be  an  accurate  statement  for  that  particular  table, 
since  the  bonds  may  not  have  been  issued  for  the 
whole  year  and  hence  a  year's  interest  may  not  yet  be 
due  ;  still  our  comparison  shows  that  at  least  $100,000 
must  be  added  in  our  calculations  to  the  requirements 
for  another  year.  ^ 

The  expenditures  in  the  table  show  $3,000,000  spent 
upon  the^roperty  and  $1,000,000  upon  equipment 
during  the  year  ;  the  other  items  make  up  a  total  ex- 
penditure of  $4,900,000.  lyct  us  now  see  how  this  sum 
was  obtained.  Allowing  for  the  discount,  $2,000,000 
was  raised  from  the  sale  of  bonds  and  $1,000,000  was 
borrowed  on  call  (/.  e, ,  can  be  demanded  by  the  lender 
at  any  time),  or  for  a  definite  (though  short)  period. 
The  remaining  $1,900,000  was  gathered  by  piecemeal. 
Debts  due  the  company  were  more  closely  collected, 
and  on  debts  due  by  the  company,  it  will  be  seen,  pay- 
ments were  deferred.     Wages  are  running  farther  in 


The  Examination  of  Railway  Reports     1 1 3 

arrears  and  $200,000  more  of  bond  interest  was  not 
paid.  There  is  a  new  item  ''  unadjusted  accounts/* 
which  in  this  table  undoubtedly  is  simply  another 
name  for  more  floating  debt.  Money  due  for  supplies 
and  for  acknowledged  claims  has  been  held  back. 
There  has  been  further  economy  in  the  already  too 
small  stock  of  materials  on  hand.  Casli  is  dwindling  ; 
let  the  reader  note  the  significant  change  in  the  word- 
ing of  this  item.  A  year  ago  it  was  **  cash,"  now  it 
is  '  *  cash  and  cash  items. ' '  While  '  *  cash  ' '  has  a 
definite  meaning  in  Wall  Street,  the  phrase  ^*  cash 
items ' '  may  cover  a  lot  of  rubbish  which  cannot  be 
turned  into  cash  at  all — notes  of  bankrupts,  disputed 
balances,  and  the  like.  It  is  not  a  harsh  judgment 
which  in  this  case  assumes  the  amount  of  actual  money 
on  hand  to  be  very  small.  Then  the  two  offsets,  ac- 
counts receivable  and  suspense  accounts,  down  in  the 
table  as  an  increase  of  assets  to  the  amount  of  $300,000, 
may  fairly  be  rejected  as  assets  altogether.  A  com- 
pany in  the  position  of  the  Great  Eastern  would  not 
allow  su(?h  accounts  to  be  so  much  increased  ;  for  being 
in  stress  for  money  it  presumably  would  have  collected 
them  if  they  had  been  good. 

The  table  of  changes  certainly  wears  a  very  unfavor- 
able aspect ;  yet  one  purpose  of  the  managers  has  been 
accomplished,  to  cover  up  among  a  number  of  items  a 
part  of  the  money  they  have  spent.  Reliance  is  put  on 
the  fact  that  stockholders  will  not  figure  through  the 
accounts. 

Now  as  to  the  $4,000,000  increase  in  cost  of  road  and 
equipment.  Every  report  should  contain  a  table  giv- 
ing in  detail  the  items  charged  to  construction  or  cap- 
ital account.  There  is  such  a  field  for  deception  or  for 
equally  ruinous  bad  judgment  in  construction  statistics 

8 


114 


Corporation  Finance 


that  the  utmost  publicity  should  be  insisted  upon.  The 
following  construction  account  is  divided  (arbitrarily  as 
to  these  figures)  into  columns  of  proper  and  improper 
charges  to  capital. 

CONSTRUCTION    ACCOUNT 

CHARGED  TO  CAPITAI, 


Properly.       Improperly. 


Road,  for  new  rails J400  cx» 

for  damages  from  wrecks  by  ac- 
cidents   

for  renewals  of  ties 

for  double  track 900  000 

for  new  bridges 200  000 

for  real  estate  bought 750  000 

for  new  stations 250  000 

Total  charged  to  road,  |3,ooo  000. 
Equipment,  for  15  replaced  engines... 

for  15  new  engines 150  000 

for  500  replaced  freight 

cars 

for  500  new  freight 250  000 

for  25  replaced  passenger 

coaches  

for    25     new     passenger 

coaches 100  000 

Total  equipment,  |i,ooo  000.  

|3,ooo  000 


feSo  000 
150  000 


150  000 


250  000 


Ji,ooo  000 


Every  active  concern  must  in  some  shape  keep  a 
depreciation  account,  to  which  shall  be  charged  certain 
sums  foT renewal  of  machinery,  etc.,  before  profits  are 
divided.  If  this  is  not  done,  the  company  will  at  the 
end  find  itself  without  plant  and  without  money.     In 


The  Examination  of  Railway  Reports     115 

railway  matters  this  is  best  accomplislied  simply  by 
replacing  cars  and  locomotives  as  they  become  worn 
out,  and  charging  directly  to  operating  expenses  the 
cost  of  such  new  cars  as  do  not  add  to  the  number  of 
cars  in  use.  In  this  way  the  quantity  and  quality  of 
equipment  or  buildings  or  track  are  kept  up  at  the 
expense  of  the  annual  earnings.  In  the  construction 
account  just  given,  $1,000,000  is  improperly  charged  to 
capital  and  paid  for  by  bonds,  because  the  items  cover 
depreciation  and  should  have  been  included  in  the 
operating  expenses.  The  test  to  be  applied  for  the 
ascertainment  of  wrong  charges  to  capital  on  equip- 
ment account  is  that  of  comparison.  Every  railway 
report  gives,  or  should  give,  a  list  of  the  niunber  of 
engines,  passenger  and  freight  cars  in  service  at  the 
close  of  the  fiscal  year.  It  is  an  easy  matter  to  calcu- 
late the  increases  from  year  to  year.  For  the  reason 
that  variations  may  at  times  occur,  it  is  better  to  take 
a  period  of  years.  If  the  increases  in  the  lists  for,  say, 
five  years,  multiplied  by  a  fair  valuation  for  each  class, 
equal  approximately  the  stuns  of  the  amounts  charged 
to  capital  for  new  equipment  during  that  period,  then 
no  wrong  charges  on  this  account  have  been  made. 
In  the  case  before  us,  we  will  compare  the  lists  on  two 
successive  years. 

STATEMENT    OF    KQUIPMKNT 


Preceding 
year. 

Present 
year. 

Increase. 

\o.  of  locomotives 

185 

200 

15 

"     "  passenger  cars 
"     "  freight  cars 

375 
29,500 

400 
30,000 

25 

500 

This  statement  of  equipment  explains  why,  in  the 
table  of  construction  just  given,  $500,000  charged  for 


1 16  Corporation  Finance 

replaced  engines  and  cars  is  marked  as  improperly 
debited  to  that  account.  The  actual  increase  in  the 
list  during  the  year  is  but  half  that  carried  in  the  com- 
pany's balance-sheet  as  cost  of  plant.  Other  items 
included  in  the  construction  table  as  improperly 
charged,  are  payments  for  train  accidents  and  for 
replaced  ties.  These,  of  course,  should  go  into  operat- 
ing expenses.  Payments  for  wrecks  may,  however,  be 
concealed  under  ''  double- track  "  or  similar  items  if  a 
company  is  determined  to  deceive.  As  to  ties,  it  is 
fair  to  assume  that  these  last  about  seven  years,  de- 
pending, of  course,  on  the  climate  and  the  kind  of 
wood  used.  If  we  estimate  2800  ties  to  the  mile  of 
single  track  as  about  the  average  requirement,  we 
have  as  an  estimate  of  yearly  renewals  400  ties  per 
mile.  Here,  again,  a  number  of  years  should  be  taken 
to  obtain  a  fair  average  ;  but,  in  the  long  run,  if  a 
road's  renewals  of  ties  fall  on  the  average  much  below 
400  ties  per  mile  per  year,  inquiry  should  be  made  as 
to  the  reason. 

As  to  rails  :  the  life  of  a  steel  rail  is  not  yet  definitely  j 
ascertained  ;  perhaps  twenty  or  twenty-five  years  may  ■ 
be  taken  in  order  not  to  be  unfair  to  the  company 
under  examination.      Estimating  the  weight  of  steel 
rails  at  seventy  pounds  per  yard,  the  required  weight , 
per  mile  of  single  track  is  one  hundred  and  ten  tons. 
This  would  assume  an  average  renewal  of  five  or  six 
tons  per  mile  per  year.     A  calculation  spread  over  a 
number  of  years  would  show  how  far  short  of  such  an 
average  a  particular  company  had  fallen.     If  its  rails 
are  new,  or  nearly  so,  such  a  calculation  would  be  of 
value  only  as  approximating  the  amount  which  will  be 
required  for  that  purpose  in  the  future. 

By  our  analysis  of  the  Great  Eastern's  construction 


The  Examination  of  Railway  Reports     1 1 7 

account  we  have  ascertained  the  amount  which  should 
have  been  charged  to  operating  expenses,  to  have  been 
$1,000,000.  This  added  to  the  $600,000  loss  on  the 
branch  line,  makes  $1,600,000  which  should  have  been 
deducted  from  income.  As  the  sum  applicable  to  divid- 
ends in  the  income  account  was  $1,500,000,  we  reach 
the  conclusion  that  the  dividend  was  not  really  earned 
and  should  not  have  been  declared. 

It  will  be  remembered  that  the  road  was  operated  for 
sixty-two  per  cent.  The  percentage  of  expenses  to 
earnings  is  of  little  use  except  as  a  guide  for  further 
examination.  Of  itself  it  is  only  the  percentage  re- 
lation between  two  sets  of  independent  figures.  If  a 
railway  earns  one  dollar  and  spends  fifty  cents,  it  is 
operated  for  fifty  per  cent.  ;  but  if  from  any  cause — 
water  competition,  let  us  say — it  can  get  but  seventy- 
five  cents  for  the  same  unit  of  service,  and  if  its  ex- 
penses per  unit  stay  at  fifty  cents,  then  it  is  operated 
for  665^  per  cent.  Usually  the  volume  of  units  of 
trafl5c  increases  as  the  charge  per  unit  falls,  so  that 
the  road  makes  as  much  gross  profit  from  the  larger  as 
from  the  smaller  receipts  per  unit  ;  but  manifestly  we 
must  go  into  details  of  the  operating  expenses  if  we 
would  form  a  judgment  upon  the  management.  Here 
are  four  statistical  tables  of  the  Great  Eastern  Railway  : 

OPKRATING    KXPENSKS 

Maintenance  of  way  and  structures %   420  cxx> 

Maintenance  of  equipment : 

Passenger  cars f  100  000 

Freight  cars 300000 

Engines 60  000        460  000 

Conducting  transportation 2,320  000 

General  expenses 1,000  000 

$4,200  000 


Ii8  Corporation  Finance 

STA'TISTICS   OF  OPERATIONS 
MII,KS    OF  RAII^WAY    OPERATED    8oO 

Passenger-train  mileage i,8oo  ooo 

Freight-train  mileage 3,200  000 

Switching,  etc.,  mileage 1,000  000 

Total  engine  mileage 6,000  000 

Number  of  passengers 800  000 

"         **         **         I  mile 36,000000 

Tons  of  jfreight 3,000  000 

"    **        '*      I  mile 700,000000 

Rate  of  fare  per  mile,  in  cents , ,03 

Rate  of  freight  per  ton  per  mile,  in  cents .008 

Mileage  of  passenger  and  baggage  cars. 9,000  000 

Mileage  of  freight  cars 96,000  000 

GENERAIv  ITEMS 

Maintenance  of  way  per  mile I525 

Average  number  of  passengers  to  each  train  mile 20 

Average  number  of  tons  to  each  freight  train  mile 220 

Average  number  of  passenger  cars  to  each  train 5 

Number  of  freight  cars  to  each  train 30 

Average  mileage  of  each  freight  car  per  day,  i'.s  .' 10 

Average  earnings  per  mile  :  *^ 

each  passenger  train %q.(30 

each  freight  train 1.75 

Cost  of  motive  power  per  engine  mile  : 

Repair  of  engines |o.oi 

fuel 05 

Engineers  and  firemen 07 

Oil  and  waste 01       ^.14 

Railway  reports  do  not  always  give  just  these  statist- 
ics, but  usually  the  information  we  need  can  be  ob- 
tained by  a  little  figuring.  The  cost  of  maintenance 
of  way  per  mile  is  easily  ascertained  by  dividing  the 
average  number  of  miles  operated  into  the  total  pay- 


The  Examination  of  Railway  Reports     119 

ments  for  that  account.  The  average  number  of  pas- 
sengers or  of  tons  of  freight  to  each  train  is  found  by 
dividing  the  train  mileage  into  the  number  of  miles 
travelled  by  passengers  or  the  tons  one  mile,  respect- 
ively. The  results  are,  therefore,  somewhat  in  the  ab- 
stract, but  they  afford  the  best  comparison  regarding 
the  economy  of  the  train  service,  one  of  the  most  im- 
portant things  to  be  considered  in  judging  railway 
properties.  It  is  necessary  to  know  the  number  of 
miles  run  annually  by  cars,  freight  cars  especially,  in 
order  that  we  may  check  the  construction  account  and 
judge  of  the  general  eflSciency  of  the  company's  manage- 
ment. 

The  amount  allowed  for  maintenance  of  way  is  too 
small  for  the  volume  of  traffic  and  number  of  trains. 
The  sum  varies  from  $2000  per  mile  in  the  case  of  our 
principal  roads,  downwards.  Generally  this  item  is 
best  judged  by  comparing  the  amounts  spent  per  year 
for  a  number  of  years  with  those  spent  by  neighboring 
companies  similarly  situated.  On  many  railroads  the 
average  annual  cost  of  necessary  repairs  and  renewals 
is  $500  on  each  passenger  coach,  $40  each  for  freight 
cars,  and  $1000  each  for  engines.  Multiplying  these 
averages  into  the  list  of  equipment  given  above,  we  find 
that  there  should  be  an  addition  of  over  a  million  dol- 
lars to  the  sum  allowed  in  the  operating  expenses  for 
repairs  and  replacement  of  equipment.  This,  of  course, 
would  increase  the  total  expenses  by  that  amount  and 
correspondingly  decrease  the  net  income.  As  we  know 
that  the  Great  Eastern  Railway  (or  any  railway)  can- 
not long  be  run  without  making  the  repairs  and  renew- 
als its  neighbors  find  necessary,  we  are  forced  to  the 
conclusion  that  if  money  enough  to  care  rightly  for  the 
property  has  been  expended  and  charged  to  current 


1 20  Corporation  Finance 

working  expenses,  the  fixed  charges  might  not  have 
been  earned.  Bankruptcy,  therefore,  awaits  the  com- 
pany, unless  heroic  measures  are  taken  to  remedy 
defects  in  management  and  save  the  property.  The 
decline  in  the  market  prices  of  the  stock  was  more 
than  warranted.  Our  inquiring  stockholder  would  do 
well  to  dispose  of  his  holdings  at  once  at  whatever 
price  he  can  get ;  unless  his  ownership  is  so  large  and 
his  knowledge  of  railway  operation  so  good  as  to 
enable  him  to  ascertain  and  himself  apply  the  proper 
remedy. 

We  have  not  yet  exhausted  comment  on  these  tables. 
The  cost  of  fuel  (five  cents  per  engine  mile)  is  not 
high  ;  and  if  we  add  two  or  three  cents  to  the  cost  of 
repairs  for  locomotives,  the  cost  of  motive  power,  per 
mile  run,  is  low, — a  point  much  in  the  company's  favor. 
The  rate  received  per  ton  per  mile  is  not  high,  and 
perhaps  a  careful  examination  of  the  commercial  condi- 
tions of  the  country  through  which  the  road  runs  would 
show  where  improvement  is  possible.  The  passenger 
department  is  grossly  mismanaged.  So  many  trains 
are  run  that  the  average  number  of  passengers  is  only 
twenty  per  train  mile.  The  average  for  the  whole 
United  States  is  about  forty-five,  and  to  carry  less  than 
thirty-five  passengers  per  average  mile  is  hardly  profit- 
able. Trains  should  at  once  be  withdrawn  until  only 
the  reasonable  demands  of  the  public  are  met.  Since 
only  half  the  present  number  of  passenger  cars  is  really 
needed,  it  was  a  gross  abuse  of  power  for  the  manage- 
ment to  purchase  more  coaches,  as  the  construction 
account  shows  they  did.  There  is  no  particular  fault 
to  be  found  with  the  lading  of  the  average  freight  train 
or  with  the  earnings  per  freight  train  mile  ;  they  are 
up  to  the  average,  if  not  beyond  it.     But  to  what  use 


The  Examination  of  Railway  Reports     121 

so  many  freight  cars  can  be  put  is  a  mystery.  It  ap- 
pears that  the  average  mileage  of  the  freight  cars  is  but 
ten  miles  per  day  ;  it  should  be  at  least  three  times 
that  number  to  be  profitable.  The  daily  mileage  of 
each  freight  car  on  the  average  is  found  by  dividing 
the  total  freight-car  mileage  by  the  number  of  cars. 
Nine  or  ten  thousand  miles  per  year  is  the  expected 
work  of  each  freight  car  on  the  average  on  a  successful 
road.  Very  likely  more  than  half  of  the  large  number 
of  cars  owned  (large  in  proportion  to  traffic  carried) 
are  standing  idle  on  side  tracks.  The  construction 
account  showed  1000  cars  bought  at  an  expense  of 
$500,000.  Not  a  single  car  should  have  been  added  to 
the  list,  since  under  good  management  one  third  the 
number  already  owned  should  carry  the  stated  volume 
of  business.  The  extra  number  of  cars  should  be 
reduced  or  loaded  out  to  other  roads,  to  be  paid  for  at 
the  standard  rate  for  use  of  foreign  cars,  about  three 
fourths  of  a  cent  per  mile  run.  It  sometimes  happens 
that  an  unscrupulous  company  will  charge  renewals  of 
equipment  to  capital  and  conceal  the  fact  by  adding 
the  new  cars  to  the  old  list  of  a  year  ago,  even  though 
it  may  not  have  in  service  the  number  of  locomotives 
and  cars  certified  to  in  the  report ;  such  unjustifiable 
additions  are  called  **  vacant  numbers."  Vacant  num- 
bers sometimes  arise  from  the  destruction  of  worthless 
cars  which  should  be  replaced  from  operating  expenses 
but  temporarily  are  not,  because  of  hard  times.  This 
is  a  legitimate  economy  if  so  stated  in  the  report  ; 
though  it  is  better  to  charge  against  income  the 
estimated  cost  of  filling  the  vacant  numbers.  If  the 
mileage  of  freight  cars  is  stated  in  the  report,  these 
juggles  with  equipment,  when  at  all  serious,  can  be 
detected.     If  the  company  is  really  short  of  cars  the 


V 


cost  of  hiring  equipment  (itemized  in  the  detailed  table 
of  operating  expenses)  will  be  a  large  and  increasing 
sum.  If  more  cars  are,  for  the  purposes  of  deception, 
kept  in  the  lists  than  are  actually  running,  either  be- 
cause old  cars  have  been  broken  up  and  not  replaced  or 
are  allowed  to  stand  in  the  yards  though  worthless,  the 
fact  will  be  revealed  by  dividing  the  number  of  cars 
into  the  total  mileage.  If  this  total  mileage  includes 
foreign  cars,  such  foreign  mileage  must  be  deducted 
and  the  mileage  of  home  cars  on  foreign  roads  added. 
If,  as  in  the  Great  Eastern  case,  the  whole  freight  ^ 
equipment  ran  an  average  of  but  3200  miles  during  the 
year,  when  the  average  should  have  been  9000  miles  or 
more,"  there  is  serious  mismanagement  or  fraud.  There 
has  therefore  been  gross  mismanagement  or  fraud  also 
in  locking  up  capital  by  the  purchase  of  unnecessary 
equipment,  which  when  bought  must  be  kept  in  repair 
though  perhaps  falling  to  pieces  through  lack  of  use.  • 
In  view  of  these  latter  criticisms  it  is  probable  that  all 
the  items  in  the  construction  account  should  receive 
careful  investigation.  The  amount  allotted  to  general 
expenses  on  a  road  carrying  a  fair  amount  of  traffic 
should  be  not  much  over  ten  per  cent,  of  the  total  ex- 
penses. Judged  by  this  test  the  Great  Eastern  man- 
agers may  be  wasting  about  $500,000  a  year.  In 
short,  the  directors  of  this  company  are  either  ''  work- 
ing*' the  road  for  their  own  benefit,  or  are  culpably 
negligent  of  their  duties  as  trustees  for  the  stockholders. 
It  is  often  of  importance  to  find  out  whether  a  com- 
pany has  much  ready  cash  or  is  likely  to  be  obliged  to 
borrow  for  interest  or  dividends.  An  estimate  upon 
this  point  is  possible.  Taking  the  balance-sheet  given 
for  the  last  fiscal  year  of  the  Great  Eastern  Railway  on 
a  former  page,  we  find  the  cash  items  as  follows  : 


^ 


0 


The  Examination  of  Railway  Reports     123 


Quick  assets. 


Quick  liabilities. 


Due  from  connect- 
ing roads $200  000 

Accounts  receiv- 
able         300000 

Suspense  accounts       200  000 

Cash  and  cash 
items 100  000 


Due       connecting 

roads f  1,000  000 

Due  for  wages 700  000 

Unadjusted  accts..  300  000 

Bills  payable 1,000  000 

Supply  accts 300  000 

Vouchers 200  000 


Excess  of  debts. 


J800  000 
2,700  000 


13,500  000 


Very  likely  the  true  state  is  a  little  worse  than  this, 
for  while  ''unadjusted'*  or  **  suspense"  debts  must 
usually  be  paid  in  full  at  some  time,  accounts  receiv- 
able or  in  suspense  often  cover  items  carried  along  in 
this  way  from  year  to  year,  and  in  part  at  least  worth- 
less or  unavailable.  The  real  cash  resources  as  indi- 
cated in  the  above  statement  may  be  fairly  set  down  as 
not  more  than  half  the  sum  stated,  or  $400,000.  The 
item  of  accrued  interest  ought  also  to  be  included  in 
the  pressing  debts,  if  the  actual  day  of  payment  is  near 
at  hand — as,  for  example,  July  ist,  when  the  fiscal 
year  closes  June  30th.  Materials  and  supplies,  prop- 
erly carried  in  the  balance-sheet  as  assets  since  the 
company's  working  capital  is  invested  therein,  are  not 
available  for  the  payment  of  current  debt  and  are  there- 
fore excluded  from  our  table.  A  glance  at  the  balance- 
sheet  shows  that  the  only  treasury  assets  which  can  be 
sold  are  the  bonds  of  the  Rich  Valley  branch,  amount- 
ing to  $5,000,000.  It  is  doubtful  under  our  showing 
whether  these  bonds  could  be  sold  at  a  heavy  sacrifice, 
if  at  all  ;  for  an  investigation  would  reveal  the  fact  that 
the  bonds  were  really  dependent  for  their  value  upon 
the  success  of  the  system,  since  the  branch  line  itself 


1 24  Corporation  Finance 

is  not  earning  the  interest.  A  proper  inquiry  at  this 
point  would  be  whether  the  Rich  Valley  is  commer- 
cially entitled  to  a  larger  proportion  of  the  combined 
earnings  ;  if  so,  its  bonds  would  be  enhanced  in  value, 
though  the  enhancement  would  be  at  the  expense  of 
the  earnings  of  the  main  line. 

Of  course,  the  selling  of  Rich  Valley  bonds  in  the 
Great  Eastern  treasury  would  only  exchange  one  form 
of  debt  for  another,  and  would  not  therefore  relieve  the 
real  situation.  The  company's  affairs  require  thorough 
overhauling.  Yet  the  fact  that  a  company  in  tempo- 
rary difl&culties  has  in  its  treasury  bonds  available  for 
sale,  is  often  important.  The  obligation  is  changed 
from  a  floating  to  a  funded  debt,  and  therefore  relieves 
the  company  from  the  fear  of  a  receivership.  Yet  such 
a  change  really  avails  nothing  in  the  long  run  unless 
the  business  or  the  management  changes  with  it  in 
such  a  way  as  to  insure  a  greater  success.  The  affairs 
of  the  company  look  desperate  ;  it  is  doubtful  whether 
such  an  entanglement  could  be  straightened  out  with- 
out a  receivership  for  a  few  years,  long  enough  to 
enable  the  pressing  debts  to  be  liquidated  without  too 
much  sacrifice  of  the  company's  assets.  Nevertheless, 
we  see  that  in  spite  of  gross  mismanagement  there  is  a 
good  traffic,  which  in  capable  hands  could  be  made  to 
earn  a  fair  revenue.  We  will,  therefore,  assume  that 
indignant  shareholders  turn  out  the  board  of  directors 
and  discharge  the  officers,  substituting  capable  and 
honest  men.  Let  us  suppose  new  directors  and  officers 
in  charge.  Of  course  the  payment  of  dividends  is  sus- 
pended and  all  energies  are  devoted  to  saving  the  prop- 
erty from  foreclosure.  In  such  large  affairs,  all  that  is 
wrong  cannot  be  righted  at  once.  Corporate  salvation 
is  a  work  of  time.     In  the  present  case  we  will  assume 


The  Examination  of  Railway  Reports     1 2  5 

that  money  could  be  borrowed  to  meet  pressing  needs, 
that  two  or  three  years'  hard  work  has  had  its  results, 
and  that  the  income  of  the  road  is  now  meeting  in 
full  all  proper  operating  expenses  and  fixed  charges, 
l^gder  these  conditions  the  income  account  would  be 
as  follows  : 

Gross  earnings ;  passenger $2,000  000 

freight 7>ooo  000 

mail,  express,  and  miscellaneous.  600  000 

Total  earnings 9,600  000 

Operating  expenses  (70  per  cent.) 6, 745  000 

Total  income 2,855  000 

Fixed  charges  :  taxes I150  000 

bond  interest 1,500000       1,650000 

Net  income 1,205  000 

Deduct    loss   on    Rich    Valley    bonds 

outstanding ^50  000 

Deduct  amounts  set  aside  to  pay  interest 

and  principal  of  old  floating  debts. . .       350  000  700  000 

Surplus  for  year,  devoted  to  improvements  and 
betterments I505  000 

This  is  very  satisfactory.  Passenger  earnings  have 
increased  by  the  judicious  issue  of  commutation  and 
excursion  tickets,  though  the  fare  received  on  the 
average  has  fallen  from  three  cents  to  two  cents  per 
mile.  In  the  intervening  years  the  new  ofiicers  have 
increased  the  volume  of  traffic.  Taxes  and  bond  inter- 
est have  increased,  and  the  losses  on  the  Rich  Valley 
branch  are  now  properly  charged.  Evidently  also  the 
new  management  has  adopted  the  policy  of  pa>4ng  off 
old  debts  by  degrees,  $350,000  being  set  aside  for  that 
purpose.  There  still  remains  a  surplus  of  $500,000, 
which  is  to  be  spent  for  improvements  on  the  property. 


126  Corporation  Finance 

Altogether  there  is  a  fair  prospect  of  resuming  divid- 
ends, so  that  those  who  purchased  the  stock  when  at 
its  lowest  point  will  very  likely  make  large  profits. 

For  the  sake  of  contrast,  the  details  of  the  operating 
expenses  are  given  :  |^ 

Maintenance  of  way J5i,ooo  ooo 

Maintenance  of  equipment : 

400  passenger  cars  at  I500. . .  |200  000 

15,000  freight  cars  at  I50 750  000 

200  engines  at  |iooo 200  000       1,1.50  000 

Conducting  transportation 4,095  000 

General  expenses 500  000 

|6,745  000 

STATISTICS 

Miles  of  railway  operated,  800. 

Passenger-train  mileage 2,500  000 

Freight-train  **       3,600  000 

Switching  "      1,200  000 

7,300  000 

No.  of  passengers,  one  mile , 100,000  000 

Tons  of  freight,  one  mile 900,000  000 

Rate  of  fare  in  cents  per  mile .02 

''      "freight     **        "      "     .008 

Mileage  of  passenger  and  baggage  cars 12,000  000 

"         *'   freight  cars 150,000  000 

No.  of  passengers  to  each  train 40 

No.  of  tons  of  freight  to  each  train 250 

A  generous  amount  is  allowed  for  maintenance ; 
when  the  plant  is  once  in  excellent  condition,  it  can  be 
maintained  at  a  less  cost  than  that  here  given.  The 
expense  for  trains  earning  revenue  (this  phrase  ex- 
cludes switching  mileage  and  the  like)  is  about  $1  per 
train  mile.  In  actual  operation,  this  expense  runs  from 
eighty  cents  upwards  per  mile  run,  varying  according 


The  Examination  of  Railway  Reports     127 

to  conditions,  particularly  the  relative  cheapness  or 
dearness  of  coal,  which  forms  a  large  item  in  all  rail- 
road expenses.  As  we  have  assumed  that  the  Great 
Eastern  Railway  obtains  its  fuel  cheaply,  the  assumed 
c(^  per  train  mile  is  fair,  indicating  reasonably  high 
expenses  for  improving  the  property  if  the  management 
is  good,  or  a  waste  of  money  if  the  management  is  bad. 
Under  the  old  state  of  a£fairs  on  this  railway,  the 
expense  per  train  mile  was  about  eighty  cents.  Our 
examination  of  details  showed  that  this  old  appearance 
of  cheapness  was  deceptive.  Whether  the  new  cost  of 
about  $1  per  train  mile  is  due  to  a  generous  care  of  the 
property  or  to  greater  waste,  can  be  told  only  by  fur- 
ther scrutiny  into  the  accounts. 

The  table  of  statistics  enables  us  to  judge  of  the  new 
management,  and  by  contrast  with  the  old  figures 
shows  important  differences.  The  number  of  locomo- 
tives and  passenger  cars  is  the  same  as  before.  These 
have  been  presumably  kept  in  good  condition,  the 
amounts  allowed  in  the  new  operating  estimates  being 
fairly  large.  Freight  cars  have  been  reduced  one  half, 
partly  by  sale  and  partly  by  the  breaking  up  of  old 
and  small  cars  which  were  uneconomical  to  use.  The 
new  management  had  to  do  the  best  they  could  with 
the  property  as  they  found  it  when  coming  into  power. 
The  number  of  passengers  per  train  has  doubled,  show-  j 
ing  more  careful  study  of  that  part  of  the  corporation 
problem.  Nothing  has  been  added  to  capital  account, 
but  the  policy  has  been  inaugurated  of  setting  aside 
certain  sums  for  the  payment  of  outstanding  unfunded 
debts.  The  old  trafiic  of  the  company  was  large 
enough  to  furnish  a  good  basis  for  the  present  better  \ 
condition  ;  the  question  was  one  of  management  ex-  i 
clusively. 


128  Corporation  Finance 

The  management  of  American  railways  is  better  than 
it  used  to  be — better  as  to  operation  and  more  exact  as 
to  the  accounts.  Nevertheless,  while  some  railways 
furnish  model  specimens  of  book-keeping  in  their  re- 
ports, others,  weighed  down  in  some  cases  b}^  tradi- 
tional policy  in  their  accounting,  publish  statements  of 
their  finances  which  are  misleading.  For  example,  the 
\ ,  practice  of  carrying  branch-line  losses  as  assets,  wrong 
/  as  the  policy  seems  when  stated  in  those  words,  never- 
'  theless  can  in  some  cases  be  justified  from  a  book- 
keeper's standpoint.  Yet  it  is  clear  that  a  railway 
company  might  continue  to  call  such  deficiencies  *  *  in- 
vestments in  subsidiary  roads, ' '  and  continue  to  issue 
bonds  to  cover  the  actual  cash  required,  until  at  last  a 
poor  year  might  not  yield  earnings  enough  to  pay 
interest  on  the  overloaded  debt.  If,  at  the  same  time, 
owing  to  the  state  of  the  money  market  and  the  spread- 
ing knowledge  of  the  road's  real  condition,  no  one 
would  lend  it  any  more  money,  a  crisis  would  be  im- 
pending, with  a  certain  loss  to  the  holder  of  the  com- 
pany's bonds  and  perhaps  an  assessment  on  the  stock. 
It  has  been  assumed  that  the  Rich  Valley,  though  not 
itself  earning  interest,  was  valuable  to  the  Great  East- 
em  because  of  the  interchanged  traffic.  In  some  cases 
these  branch  lines  may  not  be  worth  much  to  the  parent 
road,  and  may,  indeed,  have  been  '  *  unloaded  ' '  on  the 
old  road  by  unscrupulous  insiders.  In  judging  of  such 
cases,  the  ordinary  stockholder  must  rely  upon  the 
character  of  the  men  in  control.  Full  knowledge  of 
such  details  is  not  usually  possible  to  him. 

But  while  every  particular  concerning  a  road  cannot 
be  and  need  not  be  known,  it  has  been  the  purpose  of 
this  chapter  to  show  that  any  one  with  a  fair  know- 
ledge of  railroad  operations  can  find  out  for  himself  the 


The  Examination  of  Railway  Reports     129 

broad  facts  concerning  any  company,  provided  suffi- 
cient details  are  given  in  the  annual  reports,  and  pro- 
vided he  will  take  the  trouble  to  examine  them  closely. 
It  is  a  mistake  to  suppose  that  nothing  can  be  ascer- 
tained from  the  annual  reports  of  railways  ;  the  main 
facts  can  be.  It  is  often  thought  that  the  figures  can 
be  manipulated,  and  so  made  worse  than  useless  ;  this 
is  true,  but  only  to  a  certain  degree.  The  items  in  a 
railway  report  are  interdependent  in  a  way  often  un- 
suspected. For  example,  if  bonds  have  been  issued  or 
bills  payable  contracted,  some  item  or  items  on  the 
other  side  of  the  balance-sheet  must  be  increased  also. 
The  inquirer  should  then  proceed  to  look  into  such 
items  of  assets  with  a  view  to  finding  out  whether  such 
increases  are  legitimate,  and  if  so,  whether  they  com- 
mend themselves  to  his  judgment.  Charges  to  capital 
should  be  scrutinized  carefully,  with  a  glance  at  the 
items  allowed  for  maintaining  roadbed,  track,  and 
equipment  to  see  whether  these  have  been  neglected. 
Comparison  should  always  be  taken  with  a  road  simi- 
larly situated,  and  more  than  one  year's  work  should 
be  tabulated. 

The  lading  of  the  trains  can  easily  be  ascertained, 
while  a  little  study  will  show  that  the  number  of  tons 
carried  one  mile,  the  rate  per  ton  mile,  the  number  of 
train  miles  run,  the  cost  of  the  same,  and  the  net  earn- 
ings of  the  company,  are  all  related  to  each  other. 

In  order  that  the  general  facts  regarding  a  railway's 
operation  and  financial  management  may  be  open  to 
investigation,  public  opinion  should  require  that  the 
annual  reports  of  all  railways  should  contain  state- 
ments in  detail  of  every  item  of  income  and  expense, 
including  statistics  of  trains.  By  following  and  com- 
paring these  statistics  from  y«ar  to  year  and  stud3dng 


130  Corporation  Finance 

them  in  connection  with  the  statements  of  similar  rail- 
roads, an  investor  or  stockholder,  after  the  manner 
herein  set  forth,  can  form  a  fair  judgment  as  to  the 
main  facts  which  affect  the  value  of  the  company's 
bonds  or  stock. 


CHAPTER  VII 

PUBWC  POWCY  TOWARD  CORPORATION    PROFITS 

IF  we  assume  that  advancement  in  material  civiliza- 
tion is  made  possible  chiefly  through  a  cheapening 
of  the  cost  of  production  for  staple  articles,  and  if  we 
believe  that  true  progress  can  be  made  only  as  both 
labor  and  capital  receive  their  due  rewards,  we  state 
the  conditions  of  an  industrial  problem  which  point 
directly  toward  more  effective  organization.  Cheaper 
cost,  higher  wages,  and  better  profits  form  a  union  of 
blessings  which  can  be  realized,  if  realized  at  all,  in  no 
other  way  than  through  combinations  of  capital,  larger 
in  the  aggregate,  though  divided  into  small  owner- 
ships, together  with  the  best  mechanical  resources,  a 
massing  of  employees,  and  an  efiicient  oversight  of  the 
whole.  Following  industrial  precedents,  we  may  ex- 
pect that  time  will  be  required  before  the  greater  part 
of  our  commerce  in  staples  will  be  carried  on  by  such 
large  organizations,  yet  the  evolution,  though  slow,  is 
unmistakably  in  that  direction. 

Such  organizations,  so  far  as  we  can  now  see,  can  be 
best  arranged  through  coi^orations.  Just  as  the  State 
may  pass  laws  regulating  the  business  and  credit  of  part- 
nerships, so  it  may  give  charters  to  companies  and 
enact  statutes  defining  their  rights  and  responsibilities, 
lyimited  liability  is  the  essence  of  the  corporation  idea  ; 

131      ^^ 


132  Corporation  Finance 

combining  the  possibility  of  gathering  large  amounts 
of  capital  in  the  forms  of  bonds  and  shares,  with  easy 
and  legal  ways  of  dividing  that  capital  into  proportions, 
minute  yet  distinct.  The  corporation,  assured  of  a 
continued  existence  though  its  ojfficers  or  shareholders 
may  die,  offers  on  the  one  side  a  well-understood 
chance  to  investors  with  risks  small  as  compared  to  a 
partnership,  and  on  the  other  an  unequalled  oppor- 
tunity to  men  of  first-rate  administrative  ability. 

The  relation  of  such  trade  bodies  to  the  State  and  to 
the  public  may  give  rise  to  problems  with  which  suc- 
ceeding generations  must  deal.  In  the  development 
of  large  corporations  three  parties  should  be  benefited  : 
the  capitalist,  the  consumer,  and  the  laboring  man. 
But  before  the  political  or  social  economist  may  prop- 
erly discuss  the  rights  of  the  latter  two  as  to  their  fair 
share  of  the  larger  profits  which  the  corporate  form 
renders  attainable,  there  must  be  an  acknowledgment 
of  the  fairness  of  good  returns  to  the  capitalist.  With- 
out a  prospect  of  profit  no  capital  could  be  obtained  for 
investment  in  land,  buildings,  or  machinery,  and  with- 
out this  first  venture  of  capital,  few  laborers  could  find 
employment.  This  is  particularly  true  at  the  forma- 
tion of  the  corporation,  and  for  a  reasonable  number  of 
years  thereafter.  With  the  question  of  the  fairness  of 
large  corporation  profits  long  continued,  we  are  not 
now  concerned.  So  far  as  experience  goes,  we  may 
believe  that  commercial  forces,  in  the  majority  of  cases, 
are  effective  for  a  reduction  of  the  profits  of  long-estab- 
lished corporations  to  a  normal  basis. 

It  often  happens  that  this  privilege  of  making  money 
is  granted  by  public  opinion  to  firms  and  individuals, 
but  denied  to  incorporated  companies.  It  is  forgotten 
that  a  corporation,  particularly  at  the  beginning,  is  a 


Public  Policy  133 

business  enterprise  as  purely  as  a  partnership.  Pur- 
chasers of  its  bonds  or  shares  weigh  the  chances  of 
success,  and  usually  demand  concessions  in  some  way 
commensurate  with  the  supposed  risks,  before  buying. 
In  the  case  of  a  partnership,  this  practical  demand  for 
a  profit  in  proportion  to  the  danger  of  loss  and  the 
resulting  uncertainty,  is  admitted  to  be  equitable.  It 
is  no  less  so  where  the  same  business  is  imdertaken  by 
a  company.  The  owner  of  a  dwelHng-house  which  has 
doubled  in  value  collects  his  rent  on  the  advanced  val- 
uation ;  and  no  objection  is  made.  If  the  house  should 
be  owned  by  a  stock  company,  the  doubling  of  the 
annual  returns  on  the  shares  would  in  the  minds  of 
many  be  an  economic  offense.  At  the  beginning  the 
enterprise  of  building  a  costly  line  of  elevated  railway 
in  New  York  City  was  thought  to  be  a  doubtful  one. 
The  original  projector  was  able  to  secure  capital 
enough  to  build  an  experimental  piece  of  road,  but  not 
to  demonstrate  the  success  of  the  plan  commercially 
and  financially.  The  capitalists,  who  secured  control 
and  proceeded  with  the  work  of  extending  the  lines, 
believed  in  the  enterprise  and  backed  their  belief  with 
their  money  ;  yet  many  people  thought  failure  would 
be  the  result.  When  afterwards  success  was  seen  to  be 
assured,  the  payment  of  good  returns  in  some  form 
on  the  sums  originally  invested  was  believed  by  the 
capitalists  who  hazarded  their  money  to  be  their  com- 
mercial right. 

Public  opinion  seems,  indeed,  to  be  confused  between 
the  question  of  the  fairness  of  corporation  dividends  in 
ordinary  cases,  and  the  larger  and  more  difiicult  ques- 
tion of  the  equity  of  high  profits  when  earned  by  huge 
corporations  long  established  and  monopolistic  in  their 
nature.     Yet  even  in  these  latter  cases,  few  such  com- 


134  Corporation  Finance 

panies  are  monopolies  at  the  start ;  they  usually  begin 
business  under  doubts  as  to  their  financial  success,  just 
as  other  companies  do  ;  their  development  into  grasp- 
ing concerns  belongs  rather  to  the  second  stage  of  the 
corporation  problem  at  which  the  United  States  (speak- 
ing broadly)  has  hardly  yet  arrived. 

If,  then,  corporations  are  primarily  business  enter- 
prises under  a  new  form,  and  if  they  are  in  consequence 
entitled  to  business  profits  the  same  as  partnerships,  it 
becomes  proper  to  consider  the  tests  to  which  the  fair- 
ness of  such  business  profits  may  be  rightly  subjected. 
The  prevailing  ideas  on  this  subject  as  regards  corpo- 
rations are  clearly  inequitable,  and  this  injustice  is  in 
great  part  responsible  for  stock- watering  and  other  ills 
with  which  corporation  finance  is  afilicted.  Public 
opinion  still  insists  that  the  rates  of  dividends  paid  by 
corporations  shall  be  measured,  as  to  their  fairness,  by 
the  ruling  rate  of  interest  on  borrowed  money.  It  is 
constantly  said  that  five  or  six  per  cent,  annual  returns 
on  the  share  capital  of  a  company  is  all  that  should  be 
paid,  since  about  that  percentage  is  the  normal  yield 
on  bonds  or  commercial  paper  or  paid  on  notes  dis- 
counted at  the  banks.  It  is  overlooked  that  the 
standard  thus  set  is  the  rate  on  money  loaned  on  good 
collateral,  and  considered  secure  both  as  to  interest  and 
principal.  The  comparison  may  be  proper  as  between 
the  prevailing  rate  of  interest  and  that  paid  by  the 
company  on  its  bonds  ;  but  manifestly  the  returns  on 
that  part  of  the  capital  hazarded  by  the  shareholders 
should  not  be  so  judged.  If  that  rule  were  really  car- 
ried out,  if  public  opinion  had  been  able  to  limit 
returns  even  in  hazardous  enterprises  to  a  bare  inter- 
est rate,  the  community  would  be  the  worst  sufferer 
from  the  lack  of  facilities  in  transportation,  in  manu- 


Public  Policy  135 

facturing,  and  in  trading  whicli  it  now  enjoys.  The 
only  result  of  this  ill-defined  but  commercially  errone- 
ous opinion  about  the  rate  of  dividends  has  been  to 
complicate  the  whole  subject  of  corporation  investment 
and  regulation  with  a  series  of  false  issues.  We  are 
treated  to  long  discussions  and  severe  statutes  upon 
the  subject  of  water  "  in  the  stocks  and  bonds  of  rail- 
ways and  other  corporations  ;  while  the  real  point  has 
usually  been  the  commercial  justice  of  returns  larger 
than  the  rate  of  interest  on  borrowed  money  when  paid 
to  shareholders  in  companies  formed  and  managed  sim- 
ply as  business  enterprises. 

The  experience  of  all  civilized  countries  has  shown 
the  uselessness  of  all  direct  attempts  to  limit  profits  by 
legislation.  Such  attempts  merely  compel  concealment 
in  some  way,  or  dull  the  edge  of  enterprise.  For  exam- 
ple, the  charter  of  the  Boston  and  Worcester  Railroad 
(now  a  part  of  the  Boston  and  Albany),  granted  by 
Massachusetts  in  1831,  has  this  section  : 

''  Toll  is  granted  as  may  be  agreed  upon  by  the 
directors  provided  that  if,  at  the  expiration  of  ten 
years,  the  net  income  from  tolls  and  other  profits  shall 
have  amounted  to  more  than  ten  per  cent,  per  annum 
upon  the  cost  of  the  road,  the  legislature  may  take 
measures  to  reduce  the  tolls  in  such  a  manner  as  to 
take  ofi*  the  surplus.'' 

It  is  agreed  that  the  railroad  in  question  has  paid 
much  more  than  the  ten  per  cent,  yearly  allowed,  dur- 
ing the  last  sixty  years.  There  is  no  known  instance 
of  such  a  limitation  of  dividends  being  practically  en- 
forced where  commercial  profits  justified  a  higher  rate. 
The  only  legislation  which,  under  present  conditions, 
has  much  chance  of  practical  effect,  is  that  of  which 
some  lyondon  (Kngland)  gas  charters  furnish  an  illus- 


136  Corporation  Finance 

tration.  By  Act  of  Parliament  certain  of  these  gas 
companies  must  sell  the  gas  at  35.  9^.  per  1000  feet. 
For  every  penny  taken  off  this  price  to  consumers  the 
company  is  allowed  to  increase  the  dividend  one  fourth 
of  one  per  cent.  ;  for  every  increase  in  the  price,  there 
must  be  a  corresponding  dividend  reduction.  Of  course 
such  legislation  is  crude,  for  there  can  be  no  arithmetical 
ratio  between  the  prices  of  the  goods  sold  and  the 
annual  dividends  on  the  shares ;  but  it  embodies  a 
principle,  which  indeed  usually  works  itself  out  in 
rough  fashion,  that  there  must  be  a  division  of  the 
benefits  of  the  corporate  form  between  the  parties  con- 
cerned. It  would  be  inequitable  if  a  corporation 
should  keep  all  the  profits  for  its  shareholders ;  and 
equally  unjust  if  it  could  so  keep  none  of  them. 

It  is  not  necessary  to  prove  that  values  have  increased 
in  the  United  States  ;  figures,  such  as  those  of  the  cen- 
sus, showing  such  increases  between  1880  and  1890,  are 
available  for  those  wishing  to  follow  the  subject  far- 
ther. It  is  also  a  matter  of  common  knowledge  that, 
while  certain  individuals  and  firms  have  failed,  others 
have  amassed  large  fortunes.  A  number  of  firms 
have  taken  the  corporate  form  and  have  offered  their 
shares  to  the  public.  In  no  one  of  these  cases  of  incor- 
poration of  old  partnerships  was  the  original  amount 
invested  in  the  business  by  the  partners  stated  ;  the 
public,  it  is  held,  has  no  right  to  that  information. 
The  prospectuses  of  the  Proctor  &  Gamble  Co.,  The 
H.  B.  Claflin  Co.,  or  of  the  larger  corporations,  like 
the  American  Sugar  Refining  Co. ,  may  be  searched  in 
vain  for  such  information.  The  present  status  of  the 
new  company  and  its  probable  future,  based  upon  the 
profits  for  several  years  past,  are,  however,  always  set 
forth  in  the  prospectus,  and  these  facts  and  estimates 


Public  Policy  137 

really  form  the  basis  upon  which  the  amount  of  capital- 
ization the  new  company  can  bear  is  arrived  at.  What 
percentage  upon  the  original  investment  the  yearly 
profits  to  the  old  partners  have  been,  is  not  thought  to 
have  any  bearing  upon  the  value  of  the  business  at  the 
time  of  incorporation.  The  capitalization  is  fixed  at 
such  an  amount  as  will  in  the  judgment  of  the  promoters 
allow  the  shares  to  be  sold  to  the  public  at  about  their 
par  value.  If  the  profits  are  legitimate,  the  business 
stable,  and  the  financial  condition  honestly  set  forth, 
the  arrangement  is  proper.  If  the  enterprise  had  been 
started  originally  as  a  corporation,  it  is  to  be  feared 
that  the  large  profits  annually  earned  would  have  been 
considered  as  commercial  wrongs  to  the  community. 
But  whether  these  profits  are  fairly  earned  or  not,  is  a 
question  which  cannot  be  determined  by  the  percent- 
age of  such  profits  to  the  original  investment.  Their 
fairness  is  not  alone  to  be  judged  by  the  rate  of  returns, 
nor  by  the  fact  that  those  returns  are  divided  among 
partners  or  paid  to  shareholders  by  an  incorporated 
company. 

Conceding  that  in  fairness  the  value  and  profits  of  a 
corporation  should  vary  with  the  degree  of  success,  and 
be  allowed  to  grow  with  the  growth  of  business  gen- 
erally, the  question  arises  :  How  should  that  increase 
be  registered  ?  Real  estate  finds  purchasers  at  prices 
which  show  the  successive  changes  in  values.  The 
property  of  large  companies  cannot  be  so  treated.  A 
merchant  takes  an  inventory  on  a  certain  day,  and  so 
can  close  his  books  for  the  year  with  exactness.  Not 
so  a  railway,  for  example,  whose  balance-sheet  must 
continue  on  the  same  nominal  basis  of  values  from  year 
to  year  in  order  to  preserve  the  continuity  of  the  com- 
pany.   Such  corporations  can  show  the  daily  or  yearly 


138  Corporation  Finance 

fluctuations  in  the  value  of  their  assets,  and  in  the  value 
of  their  stocks  and  bonds  based  upon  those  assets,  only 
by  changes  in  the  market  prices.  This  occasions  no 
trouble  in  the  case  of  industrial  corporations  whose 
stock  is  in  few  hands  ;  but  in  the  case  of  companies 
whose  shares  are  owned  largely  by  persons  exercising 
no  direct  control  over  its  affairs — by  investors,  in  short 
— other  questions  arise  ;  when  increased  profits  are  to 
be  divided  higher  dividends  must  be  paid  or  additional 
stock  issued.  Usually  the  stock  is  ''  watered ''  to  make 
the  capitalization  conform  in  a  rough  way  to  the  value 
of  the  property  as  determined  by  its  probable  earning 
capacity.  During  the  flush  times  following  the  resump- 
tion of  specie  payments  in  1879,  the  railways,  particu- 
larly those  west  of  Chicago,  felt  the  full  effects  of  the 
improved  conditions  and  good  crops.  They  made 
money  rapidly.  The  Chicago,  Rock  Island,  and  Pacific 
Railway  Company,  for  illustration,  paid  gj^  per  cent, 
dividends  on  its  then  capital  stock  in  the  fiscal  year 
ending  March  31,  1879,  and  ten  per  cent,  in  1880. 
Finding  its  profits  still  increasing,  the  company,  in 
June,  1880,  doubled  its  capital  stock,  giving  to  the 
holders  two  shares  for  one.  The  prognostications  of 
its  officers  were  for  the  moment  justified,  for  the  com- 
pany on  its  doubled  shares  paid  6^  per  cent,  in  divi- 
dends in  1 88 1,  and  seven  per  cent,  in  1882. 

Stock-watering  in  this,  its  innocent  form,  is  not  an 
attempt  to  cover  up  extortion,  so  much  as  to  solve  a 
commercial  question.  It  is  not  a  cause  of  an  increase 
in  profits,  but  rather  an  effect  of  such  increase, 
whose  fairness  toward  customers  should  be  judged  in 
other  ways  and  by  other  means.  The  prejudice  in  the 
public  mind  against  the  distribution  of  dividends  by 
corporations  at  a  percentage  higher  than  the  usual 


Public  Policy  139 

interest  upon  loans,  makes  the  public  itself  in  a  meas- 
ure responsible  for  such  shares  of  unpaid  stocks  as  are 
issued  to  conceal  the  fact  that  the  earnings  are  larger 
than  the  usual  borrowing  rate. 

The  remedy  for  stock- watering,  therefore,  even  in  its 
innocent  form,  is  not  additional  law  but  a  change  in 
public  opinion,  which  shall  allow  the  payment  of  ten, 
twelve,  or  fifteen  per  cent.,  if  legitimately  earned,  to 
the  shareholders  of  corporations  organized  for  business 
purposes.  It  would  certainly  be  a  gain  in  honesty  if 
the  capital  of  a  company  could  openly  be  stated  at  a 
sum  no  larger  than  the  amount  actually  invested. 
This  would  be  the  result  much  oftener  than  now  if  such 
returns  as  are  above  suggested  could,  without  protest 
— because  of  that  fact, — be  paid  if  earned.  But  this  is 
not  all.  The  community  by  its  feeling  against  high 
corporation  dividends  deprives  itself  of  a  certain  natural 
protection  against  unfair  earnings  ;  because  if  such 
were  openly  paid  competition  would  be  oftener  at- 
tracted. The  tendency  of  an  open  return  would  be 
toward  a  lower  return.  In  the  case  of  the  Chicago, 
Rock  Island,  and  Pacific  Company  just  mentioned,  the 
extreme  profitableness  of  traffic-carrying  in  the  years 
following  1880  was  found  not  to  be  lasting.  After  pay- 
ing seven  per  cent,  in  dividends  upon  the  doubled  stock 
yearly,  from  1882  to  1887,  the  company  distributed  but 
four  per  cent,  in  the  years  from  1889  to  1893,  thus 
bringing  the  real  returns  to  about  the  same  rate  as 
ruled  before  the  watering.  Had  the  original  capital 
not  been  doubled  this  latter  return  would  not  seem  so 
small.  What  the  community  has  lost  in  freights  and 
facilities,  through  the  efforts  of  the  managers  to  pay 
dividends  on  doubled  capital  at  a  rate  which  should 
nominally  be  as  high  as  the  usual  interest  on  borrowed 
money,  can  only  be  a  matter  of  conjecture. 


140  Corporation  Finance 

The  tendency  of  corporation  managers,  under  the 
pressure  of  public  protest  against  high  dividends,  to 
water  the  capital  has  been  much  accelerated  by  the 
financial  law  that  stock-watering  actually  increases 
market  values.  If  a  company  is  paying  ten  per  cent, 
annually  in  dividends,  its  shares  will  be  quoted,  let  us 
say,  at  175.  If  now  the  company  doubles  the  number 
of  its  shares  and  continues  to  pay  five  per  cent.,  its 
new  stock  will  be  quoted  at  about  par.  The  original 
holder,  while  receiving  the  same  aggregate  dividends 
as  before,  finds  his  principal  increased  in  value.  The 
same  law  holds  good  when  shares  are  below  par.  If  a 
company's  stock  is  quoted  at  sixty,  and  a  stock  divid- 
end of  fifty  per  cent,  be  declared,  the  quotations  will 
not  fall  to  forty  as  they  ought.  This  fact,  probably 
explainable  on  the  previously  mentioned  theory  that 
share  values  are  in  part  based  on  the  interest  rate,  has 
always  been  a  strong  incentive  to  stock- watering. 

Another  objection  to  stock- watering  is  that  while  it 
provides  a  method  by  which  capitalization  and  profits 
may  correspondingly  increase,  it  afibrds  no  means  of 
registering  a  decline  in  those  profits,  for  shares  once 
issued  cannot  readily  be  found  and  called  in.  In  spec- 
ulative America  fluctuations  in  business  profits  are  to 
be  expected,  and  one  of  the  embarrassing  things  in 
Wall  Street  is  the  presence  there  of  shares  having  little 
or  no  intrinsic  value  but  which  may  be  used  by  unscru- 
pulous and  sometimes  almost  penniless  adventurers  to 
obtain  possession  of  a  railway  or  other  company.  The 
temptation  in  such  cases  is  great  for  the  men  thus 
placed  in  control  to  recoup  themselves  in  some  way  for 
the  cost  of  purchasing  that  control.  Low-priced  stocks 
cannot,  of  course,  be  avoided,  but  their  number  might 
be  largely  decreased  if  we  could  remove  from   the 


Public  Policy  141 

exchanges  those  shares  which  represent  *' water*' 
principally,  and  which  have  fallen  below  the  expect- 
ations of  optimistic  stock-waterers.  The  well-known 
early  history  of  the  Erie  Railway  furnishes  a  good 
illustration.  Yet  here,  as  before,  we  must  first  remove 
the  cause  of  the  trouble  ;  namely,  the  public  feeling 
against  good  corporation  profits  based  upon  the  origi- 
nal investment.  The  argument  of  the  stock-waterer 
always  is,  that  in  no  other  way  can  he  secure  profits 
commensurate  with  his  risks,  even  if  fairly  earned  ; 
and  it  is  an  argument  which  has  its  force. 

While  the  amount  of  capitalization  has  little  effect 
upon  the  rates  charged  by  the  railways — for  it  is  in 
reference  to  railways  that  the  question  has  been  most 
discussed — the  indirect  results  of  excessive  capitaliza- 
tion are  evil.  If  a  company's  capital  stock  has  been 
doubled  and  the  shares  now  receive  (let  us  say)  five 
per  cent.,  these  shares  are  sold  to  innocent  holders 
on  the  basis  of  a  five  per  cent,  return.  If,  for  any 
reason,  the  dividend  should  be  reduced  to  four  per  cent, 
there  are  immediate  protests  from  the  then  share- 
holders, for  the  reason  that  the  apparent  returns  are 
below  the  nominal  rates  of  interest.  But  if,  on  the 
other  hand,  the  company  had  been  allowed  to  continue 
payments  of  ten  per  cent,  upon  the  original  number  of 
shares,  that  percentage  of  payment  for  good  commercial 
reasons  could  be  reduced  to  eight  per  cent,  without  so 
much  complaint — the  reduction  in  the  actual  earnings 
of  the  company  being  the  same  in  both  cases.  It  is 
because  of  this  that,  when  a  decline  in  profit  comes, 
stock-watering  has  a  direct  effect.  The  managers 
knowing  that  a  reduction  in  the  dividend  rate  from 
four  to  five  per  cent,  will  be  very  unpopular,  strive  in 
every  way  legitimately  and  illegitimately  to  continue 


142  Corporation  Finance 

the  old  payments.  They  will  withdraw  trains,  will 
discharge  employees,  will  buy  less  supplies,  and  in 
every  way  will  endeavor  to  increase  their  net  earnings 
up  to  the  former  amount,  with  the  result  that  the 
public  are  deprived  of  facilities  to  which  they  are  en- 
titled and  which  they  might  otherwise  obtain  ;  while 
at  the  same  time  the  industrial  depression  is  aggra- 
vated by  the  larger  number  of  men  thrown  out  of  work 
directly  through  the  action  of  the  company  in  their 
discharge  and  indirectly  in  the  refusal  to  purchase  the 
usual  amount  of  material  and  supplies.  ,  Here,  again, 
the  condemnation  goes  farther  than  complaints  against 
the  existing  management  and  touches  the  source  of 
the  trouble,  viz.,  the  attempts  of  the  company,  per- 
haps years  before,  to  placate  public  opinion  while  at 
the  same  time  paying  the  high  dividends  to  which 
its  shareholders  considered  themselves  entitled.  There 
is  reason  for  thinking  that  the  former  lack  of  train 
service  on  the  New  York  City  Elevated  and  the  de- 
ficiency in  other  facilities  (such  as  the  proper  lighting 
of  the  cars),  of  which  loud  and  frequent  complaints 
were  made,  can  be  traced  back  to  the  time  when  the 
owners,  finding  their  projected  profits  more  than  five 
or  six  per  cent,  on  the  original  cost,  issued  the  watered 
stock  of  the  Manhattan  Company  to  correspond  with 
the  expected  increase  in  dividends.  Had  public  opin- 
ion allowed  the  payment  of  ten  or  twelve  or  fifteen  per 
cent,  on  the  original  capitalization,  it  is  possible  that 
better  service  would  have  afterwards  been  given,  even 
though  the  dividends  had  then  been  reduced  to  eight 
per  cent.  Public  opinion  against  high  corporation 
returns  is  thus  responsible  indirectly  for  the  later  pub- 
lic complaints  of  overcrowding  and  other  ills. 

What  has  been  considered  may  be  called  the  inno- 


Public  Policy  143  * 

cent  form  of  stock- watering.  But  all  stock- watering  is 
not  innocent.  An  unreal  prosperity  may  be  brought 
about  through  an  illegitimate  curtailing  of  expenses 
and  in  other  ways,  so  that  an  extra  issue  of  stock  may 
falsely  be  made  to  seem  justifiable  on  grounds  of  large 
but  fair  profits.  Or  honest  prosperity  may  come  up 
quickly,  to  fall  away  as  quickly.  In  either  case,  whether 
through  fraud  or  error,  the  increase  of  capital  stock 
may  be  commercially  unwarranted  and  a  source  of  loss 
to  innocent  investors.  Again,  parties  in  control  of  a 
railroad  or  other  large  corporation  owning  compara- 
tively few  shares,  may  decide  suddenly  to  distribute 
new  shares  free  ;  and,  by  taking  advantage  of  their  ex- 
clusive information,  may,  if  unrestrained,  make  large 
sums  of  money  for  themselves.  Or,  further,  a  com- 
pany's directors,  to  perpetuate  their  control,  may  issue 
new  shares  to  themselves  at  merely  the  cost  and  trouble 
of  buying  old  shares  on  a  margin.  This  may  result  in 
giving  over  to  men  not  eqtiitably  the  real  owners,  the 
management  of  an  important  property.  Such  control 
is  not  likely  to  be  exercised  for  the  public  good,  but 
rather  for  speculative  purposes.  Such  stock-watering 
as  this  is  an  abuse  of  the  principles  of  good  corporation 
finance,  against  which  it  is  the  right  of  the  State  to 
protect  itself  by  all  legitimate  means.  Yet,  until  high 
returns  are  freely  allowed,  the  distinction  between  the 
right  and  the  wrong  of  the  practice  is  one  always  to  be 
borne  in  mind.  The  laws  of  New  York  State  regard- 
ing railways  try  to  meet  this  difiiculty.  Its  statutes 
provide  that  no  increase  of  capital  stock  shall  be  valid 
unless  approved  by  a  two-thirds  vote  of  the  share- 
holders at  a  meeting  called  for  that  purpose  after 
twenty  days*  notice  to  each  stockholder,  and  unless 
also  approved  by  the  Board  of  Railroad  Commissioners. 


144  Corporation  Finance 

A  further  amendment,  passed  in  1890,  adds  that  no 
stock  shall  be  issued  except  for  money,  labor,  or  prop- 
erty. In  passing  upon  applications  for  increase,  the 
Board  since  1883  has  wisely  interpreted  the  statute  as 
not  condemning  such  issues  where  cause  is  shown. 
The  Board  consents  to  an  increase  when  the  new  stock 
is  to  be  sold  and  the  proceeds  spent  upon  the  property  ; 
but  if  the  stock  is  to  be  distributed  free,  then  the  total 
capitalization  (bonds  and  stock)  must  not  exceed  the 
cost  of  the  property.  It  is  the  custom  to  include  in  the 
term  cost,  all  improvements  paid  for  out  of  revenue. 
Practically,  therefore,  when  such  an  unpaid  issue  seems 
expedient  for  sound  commercial  reasons,  but  little 
stands  in  the  way  of  the  Board's  approval ;  for  ex- 
penditures on  the  property  above  cost  of  mere  mainten- 
ance from  year  to  year  can  usually  be  shown  by  all 
prosperous  roads ;  yet  it  would  be  better  to  increase 
dividends  than  to  increase  the  capitalization.  On  the 
other  hand,  the  New  York  statutes  have  apparently 
stopped,  or  at  least  rendered  very  difficult,  the  fraud- 
ulent cases  of  stock  issue  just  referred  to.  The  neces- 
sary vote  of  so  large  a  proportion  of  stockholders  after 
a  three-weeks  notice  of  the  reason  for  calling  them 
together,  renders  the  action  of  a  minority-holding  Board 
of  Directors  practically  impossible  should  such  a  board 
attempt  to  give  money  or  control  to  themselves  by  a 
sudden  issue.  The  real  owners  must  first  approve  of 
the  plan.  Then  the  public  stockholders'  meeting  and 
the  public  argument  before,  and  investigation  by,  the 
Board  of  Railroad  Commissioners  take  so  much  time 
that  all  concerned  have  an  opportunity  in  which  to 
arrange  their  holdings  for  the  change.  There  is,  of 
course,  the  further  objection  to  any  issue  of  share 
capital   without   full   payment,   however  justified  by 


Public  Policy  145 

trade  circumstances,  that  it  really  gives  to  a  holder  at 
once  and  at  a  particular  time  that  increase  in  value 
which  may  have  been  accruing  for  years.  But  by  such 
laws  as  these  of  New  York,  the  State,  until  public 
opinion  as  to  corporation  profits  changes,  has  gone  as 
far  as  it  rightfully  can  to  protect  all  interests.  No 
statute  can  give  exact  justice,  to  every  complainant. 
To  stop  all  free  issues  of  stock,  even  the  innocent,  would, 
in  the  present  state  of  opinion  upon  the  unfairness  of 
high  corporate  dividends,  put  a  check  upon  corporate 
enterprise  which  would  work  injury  to  the  public  as  a 
whole.  The  State  selfishly  wishes  its  capitalists  to 
realize  enough  returns  from  incorporated  capital  so 
that  as  many  railroads  as  are  needed  may  be  built, 
the  public  thus  getting  facilities  in  transportation  not 
otherwise  attainable.  The  State  of  Massachusetts  in 
1894  enacted  amendments  to  its  railroad  laws,  which 
forbid  the  free  issue  of  stock  under  any  circumstances  ; 
issues  of  shares  are  lawful  only  after  approval  by  the 
Board  of  Railroad  Commissioners  and  for  the  purposes 
certified  to,  and  must  be  sold  to  shareholders  at  auction 
at  not  less  than  par,  or  at  the  market  value  if  more 
than  par.  Such  absolute  prohibition  of  stock- watering 
is  economically  justifiable  only  where  no  limit  is  put 
upon  corporation  dividends  either  in  public  opinion  or 
indirectly  through  legislation  intended  arbitrarily  to 
reduce  charges. 


CHAPTKR  VIII 

CORPORATION  RE^ORGANIZATIONS  AND  RKCKIVKR- 
SHIPS 

AlyTHOUGH  as  has  already  been  stated,  the  corpo- 
ration form  is  best  adapted  for  those  businesses 
which  meet  a  public  demand,  whose  volume  of  trading 
or  traffic  or  manufacture  is  apparently  steady,  and 
whose  profits  under  good  management  may  be  ex- 
pected to  be  reasonably  uniform,  and  although  under 
such  conditions  insolvency  should  be  rare,  yet  incorpo- 
rated companies  at  times  become  bankrupt — that  is, 
are  unable  to  pay  their  floating  or  funded  debts.  If 
such  corporate  insolvencies  in  any  line  of  business  con- 
stitute a  larger  percentage  than  is  shown  by  the  gen- 
eral average  throughout  the  United  States,  a  percentage 
larger  either  in  the  proportion  of  bankrupts  to  the  whole 
or  in  the  proportion  of  assets  to  liabilities,  then  it  is 
important  for  the  welfare  both  of  investors  and  of 
the  public  that  careful  investigation  should  be  made 
to  ascertain  the  causes  of  such  undue  percentages. 
Perhaps  the  reasons  for  such  large  proportion  of 
bankrupts  may  lie  in  the  fact  that  the  earnings  of 
the  company  from  some  cause  have  been  reduced 
so  fast  that  the  expenses  could  not  correspondingly 
be  cut  down  ;  or  it  may  be  that  the  capitalization 
of  the  company  was  in  the  first  place  arranged  on  a 
false  basis;  or  perhaps  the  failure  may  have  come  from 


Reorganizations  and  Receiverships      147 

a  combination  of  these  causes.  Sometimes,  also,  wide- 
spread commercial  disasters,  such  as  the  failures  of 
crops  over  a  large  section  of  the  country,  may  account 
for  the  temporary  embarrassment ;  although  even  in 
such  a  case  the  possibility,  in  a  concern  whose  finances 
have  been  conservatively  managed,  ought  long  ago  to 
have  been  taken  into  account. 

But  from  whatever  cause  arising  or  whatever  the  per- 
centage may  be  of  those  companies  which  have  failed 
to  have  achieved  success,  the  fact  of  the  inability  of 
any  company  to  pay  its  debts  brings  up  at  once  a  large 
number  of  financial  problems  of  extreme  difficulty  and 
delicacy.  The  affairs  of  the  simple  trading  company, 
when  forced  to  succumb,  may  prove  comparatively  easy 
of  adjustment ;  but  not  so  with  large  companies.  Our 
great  railway  systems,  for  example,  have  grown  to 
their  present  size  by  degrees  through  the  construction 
or  absorption  into  the  system  of  lines  or  branches  once 
independent,  or  which  may  yet  be  nominally  considered 
so.  The  credit  of  such  a  huge  railway  system  is  also  a 
matter  of  growth;  but  a  good  credit  once  attained  does 
not  yield  easily  to  the  first  rumor  of  disaster.  The 
managers,  properly  careful  for  the  interest  of  the  share- 
holders, put  the  best  face  upon  the  declining  revenues 
in  the  hope  that  the  deficit  may  be  but  temporary — and 
indeed  by  helping  to  tide  over  a  period  of  embarrass- 
ment through  the  means  of  old-established  credit,  the 
managers  of  such  a  system  have  in  many  instances 
really  saved  the  property  for  the  shareholders.  In . 
other__cases,  however,  where  the  evil  was  too  deep- 
seated  to  be  removed  or  where  the  embarrassment  con- 
tinned  so  long  that  it  could  be  no  longer  ignored, 
the  confession  of  insolvency  has  found  the  afiairs  of  the 
company  in  a  most  unfortunate  shape. 


148  Corporation  Finance 

The  receivers,  upon  appointment,  have  been  ordered 
by  the  court  to  pay  off  those  back  debts  which  properly 
should  have  been  discharged  at  the  time  of  their  incur- 
ring from  current  revenues,  but  which  were  allowed  to 
accumulate  in  order  to  enable  the  managers  to  maintain 
the  appearance  of  solvency.  As  these  claims  are  made 
a  first  lien  upon  the  property  either  with  or  without  the 
issue  of  receivers'  certificates,  usually  the  property 
must  remain  in  receivers'  hands  at  least  as  long  as  it 
may  be  necessary  to  accumulate  from  the  revenues 
sums  sufiicient  to  provide  for  these  prior  claims.  If, 
after  a  time,  it  is  found  that  the  payment  of  these 
claims  from  revenues  is  impossible,  or  where  receivers' 
certificates  have  been  issued  for  this  very  purpose  and 
are  now  outstanding,  then  these  sums  must  be  taken 
into  account  by  the  reorganizers  of  the  company  as  so 
much  which  must  be  raised  by  the  owners  of  the  prop- 
erty before  it  can  be  turned  over  to  them. 

In  addition  to  the  sums  of  money  thus  directly  re- 
quired, it  is  almost  always  found  that  other  cash  amounts 
are  also  necessary.  Since  a  railway  system  does  not 
plunge  at  once  into  insolvency,  it  usually  finds  itself 
tending  in  that  direction  for  a  longer  or  shorter  time 
previous  to  the  final  confession,  and  it  commonly  hap- 
pens during  these  months  or  years  when  the  stress  of 
the  circumstances  began  to  bear  hard  upon  them,  that 
the  managers  have  omitted  to  do  many  things  which 
the  business  of  the  company  really  required.  In  the 
case  of  railways  the  roadbed  may  have  been  long  neg- 
lected without  absolutely  going  below  the  standard  of 
safety.  Repairs  to  wooden  bridges  or  trestles  have 
been  delayed  and  renewals  of  rails  and  ties  have  been 
put  off,  so  that  the  real  requirements  of  the  property 
are  not  revealed  until  a  receivership  makes  conceal- 


Reorganizations  and  Receiverships      149 

ment  no  longer  advisable.  When  that  receivership 
comes  and  before  reorganization  plans  can  be  drawn 
up,  the  amount  of  money  necessary  to  be  spent  in  order 
to  make  good  all  depreciation  and  to  render  the  plant 
capable  of  the  most  economic  working  must  be  de- 
finitely known.  This  is  the  time,  too,  for  an  outlook 
into  the  future  when  the  possible  changes  in  transport- 
ation rates  or  in  the  services  demanded  should  be  met 
by  some  arrangement  for  granting  to  the  reorganized 
compan)^  certain  sums  of  money  year  by  year  for  this 
future  use.  Altogether  the  cash  requirements  for  the 
present  and  for  the  future  constitute  sums  which  must 
be  raised  in  reorganization  either  by  assessments  upon 
the  shares  and  bonds  or — what  amounts  to  the  same 
thing  —  by  some  arrangement  which  will  allow  of  a 
prior  mortgage  upon  the  property  sufficient  to  accom- 
plish these  results.  Usually,  also,  it  is  necessary  that 
the  accounts  of  the  defaulting  company  should  be  gone 
over  carefully  in  order  that  the  real  earnings  of  the 
property,  u^adidterated  through  bookkeeping  assets  or 
suspense  accounts  or  padding  of  any  kind,  should  be 
ascertained. 

With  these  figures  before  them  and  with  the  outlook 
for  business  in  general  and  in  the  section  of  the  country 
immediately  concerned  in  particular,  the  banking  firm 
or  committee  are  able  to  determine  within  reasonable 
limits  what  the  earning  power  of  the  company  after 
reorganization  will  be.  Here,  then,  are  the  elements  / 
of  the  problem  at  the  beginning.  A  certain  amount  of 
cash  must  be  raised  to  pay  off  debts  and^o  make  good 
the  deficiencies  in  the  depreciation  account ;  allowance 
must  be  made  for  the  cash  requirements  of  the  future  ;  ^ 
and  finally  all  the  fixed  charges  of  the  reorganized 
company  must  be  brought  so  far  below  the  assumed 


150  Corporation  Finance 

earnings  as  to  give  to  the  new  bonded  capital  a  good 
standing  and  credit  at  once  upon  all  the  exchanges. 

It  having  been  determined  to  what  extent  the  present 
bond-  and  shareholders  must  suffer  loss  in  order  to 
bring  the  capital  of  the  new  company  within  the  earn- 
ing limits  at  the  time  of  reorganization,  the  next  prob- 
lem is  the  division  of  this  loss  among  the  old  security 
holders.  This  is  a  task  demanding  the  widest  know- 
ledge combined  with  the  best  financial  judgment. 
Under  our  assumption  the  railway  system,  now  insolv- 
ent, is  composed  of  many  different  parts,  each  having 
upon  it  bonds  varying  in  value,  in  interest  charges, 
and  in  length  of  time  to  maturity,  whose  liens  upon  the 
various  properties  may  also  be  so  interlaced  as  to  make 
their  disentanglement  a  very  difficult  thing  indeed. 
Very  likely  there  are  prior  lien  mortgages  upon  the 
older  parts  of  the  road  on  which  the  interest  charges 
have  unquestionably  been  earned.  Where  such  is  clearly 
the  case,  such  bonds  should  not  be  asked  to  surrender 
any  part  of  their  principal  or  interest.  A  fundamental 
axiom  in  corporation  financiering  is  that  bonds  which 
are  unquestionably  good  should  unquestionably  be 
paid.  Nothing  tends  to  throw  discredit  upon  corpora- 
tion securities  so  much  as  a  lack  of  discrimination  in 
cases  of  insolvency  between  bonds  which  are  good  and 
those  which  are  not. 

Perhaps  there  is  also  a  first  mortgage  upon  the  entire 
system  whose  interest  has  been  earned  ;  if  so,  the  loss 
should  fall  upon  the  junior  securities  ;  or  perhaps  one 
of  the  difficulties  of  reorganization  begins  at  this  point. 
It  may  be  that  the  main  line  has  earned  the  interest  on 
these  first-mortgage  bonds,  to  judge  from  the  state- 
ments prepared  in  the  auditor's  office  ;  but  it  is  im- 
portant to  inquire  whence  comes  the   traffic  whose 


Reorganizations  and  Receiverships      151 

carriage  has  yielded  this  profit  ?  There  may  be  branch 
lines  which  give  to  the  system  so  much  of  its  volume 
of  business  that  without  them  interest  on  the  first-mort- 
gage bonds  would  not  have  been  earned  ;  it  may  be 
that  valuable  terminals  in  the  large  cities  are  occupied 
by  the  company  subject  to  mortgages  of  their  own  ;  or, 
again,  perhaps  contracts  of  various  kinds  have  been 
entered  into  with  connecting  roads  which  on  their  face 
are  tmprofitable,  and  yet  if  those  contracts  were  an- 
nulled the  resulting  indirect  loss  to  the  company  might 
seriously  imperil  the  interest  on  the  first  mortgage 
which  we  are  considering.  Manifestly,  in  the  face  of 
such  complications,  it  will  not  do  to  say  that  interest  on 
these  first-mortgage  bonds  has  been  earned  and  should 
be  paid,  while  at  the  same  time  no  allowance  is  made 
for  interest  upon  the  terminal  bonds  or  branch-line 
obligations  or  contracts  with  connecting  lines.  If  it  is  a 
question  of  division  of  the  losses  between  them,  the 
exact  proportion  which  each  should  suffer  can  only  be 
determined  after  a  careful  search  into  the  whole  mat- 
ter and  after  a  full  investigation  into  the  claims  of  each 
one  of  these  from  a  transportation  point  of  view. 

It  is,  in  a  majority  of  cases,  useless  for  the  holders 
of  bonds  having  a  lien  upon  a  specific  piece  of  road  to 
think  of  foreclosing  their  mortgage  and  taking  the 
property  covered  by  it  out  of  the  system  to  make  it 
independent.  An  exception,  of  course,  must  be  made 
in  the  cases  of  property  such  as  a  terminal  in  a  large 
city,  which  may  be  essential  to  the  business  of  the  de- 
faulting company  and  yet  which  may  be  so  situated  as 
to  be  easily  turned  over  to  and  used  by  some  other 
company.  In  such  cases,  of  course,  there  is  no  alter- 
native but  to  keep  such  terminals  in  the  system  by 
paying  interest  upon  the  bonds  ;  usually  the  courts  are 


f^ 


152  Corporation  Finance 

quick  to  recognize  the  exigencies  of  the  situation  and 
to  authorize  the  receivers  to  pay  such  interest  even  at 
the  expense  of  the  remaining  parts  of  the  trust  estate. 
Usually,  however,  a  piece  of  property,  even  though 
covered  by  a  separate  mortgage,  finds  its  chief  value  as 
a  component  part  of  the  system  as  a  whole.  The 
reason  for  the  amalgamation  of  separate  railways  into 
one  system  is  that  the  business  as  a  whole  may  be 
administered  to  the  best  advantage  of  all.  Under 
these  conditions  the  individuality  of  any  one  part  of 
the  system  is  in  time  lost  and  cannot  be  easily  regained 
even  under  a  separate  ownership  through  foreclosure 
of  that  particular  mortgage.  There  is  something, 
therefore,  beyond  mere  words  in  the  disinclination  so 
often  stated  by  the  courts  to  allow  any  ' '  disintegration 
of  the  system, ' '  and  there  is  likewise  good  reason  for 
the  further  order  that  at  any  sale  for  the  purposes  of  re- 
organization the  whole  shall  be  offered  as  one  parcel. 
This  is  the  true  policy,  not  only  from  the  point  of  view 
of  the  investor  which  we  have  just  been  considering, 
but  also  from  that  of  the  public  whose  facilities  for 
quick  and  cheap  transportation  would  be  seriously  inter- 
fered with,  were  an  old  system  allowed  to  be  broken 
into  its  separate  parts  by  reason  of  differences  of  opin- 
ion between  the  bondholders  as  to  the  values  of  their 
respective  mortgages.  The  same  reasoning  with  modi- 
fications suited  to  the  circumstances  applies  to  corpora- 
tions other  than  railways  which  have  been  conducting 
large  business  operations. 

Stockholders  to  whom  belong  all  the  profits  of  the 
enterprise  should  under  ordinary  circumstances  be  will- 
ing to  bear  the  losses.  It  is  upon  this  principle  that 
the  cash  requirements  of  an  insolvent  company,  which 
have  just  been  referred  to,  are  usually  made  up  by  an 


Reorganizations  and  Receiverships       1 53 

assessment  upon  the  shares.  But  this  principle  is  it- 
self limited  by  expediency.  If,  under  the  influence  of 
impending  trouble  and  actual  insolvency,  the  quota- 
tions for  the  shares  on  the  exchanges  have  fallen  to 
very  low  figures,  a  large  assessment  levied  upon  each 
share  might  indeed,  if  carried  out,  result  in  the  wiping 
out  of  such  stock  under  a  reorganization,  but  would  not 
bring  into  the  treasury  of  the  new  company  any  cash  ; 
the  old  shareholders  would  prefer  to  lose  their  holdings 
rather  than  to  pay  the  assessment  demanded,  unless 
they  were  convinced  that  the  prices  of  the  new  shares 
upon  the  exchanges  after  reorganization  would  at  least 
be  higher  than  the  amount  of  the  assessment.  If  the 
shares  alone  are  asked  to  furnish  the  money  for  the 
cash  requirements  and  at  the  same  time  to  stand  the 
brunt  of  the  reorganization  generally,  the  new  stock 
to  be  given  in  exchange  for  the  assessment  might  be 
of  little  value.  From  the  nature  of  the  case  the 
equities  of  a  reorganization  cannot  be  proved  like  a 
mathematical  problem,  but  are  matters  of  individual 
judgment ;  hence  able  lawyers  employed  by  aggrieved 
shareholders  are  often  able  to  bring  forward  facts  and 
arguments  to  such  an  extent  as  to  make  doubtful  or 
delay  the  carrying  out  of  any  plan  of  reorganization  to 
which  their  clients  are  unanimously  opposed.  More 
than  that,  the  mortgages,  under  whose  terms  the  bond- 
holders must  act  in  foreclosing,  often  contain  sections 
whose  exact  meaning  perhaps  is  doubtful,  or  whose 
provisions  cannot  be  quickly  carried  out,  offering 
chances  for  long  legal  delays.  It  is  sometimes  possible 
for  the  shareholders  to  oppose  the  foreclosure  of  a 
mortgage  so  skilfully  as  to  make  the  carrying  out  a 
matter  of  years.  For  all  these  reasons  it  is  customary 
in  drawing  up  plans  of  reorganization  to  consult  the 


154  Corporation  Finance 

so-called  **  rights*'  of  the  stockholder  to  as  great  a 
degree  as  is  consistent  with  j  ustice  to  all  concerned. 

The  practical  elfect  of  this  small  deference  to  the 
shareholder  is  to  put  a  part  of  the  losses  under  reorgan- 
ization upon  the  junior  securities  ;  that  is,  upon  those 
mortgages  which  of  course  come  ahead  of  the  stock, 
but  whose  lien  upon  the  property  is  subsequent  to  the 
older  bonds.  Perhaps  the  cash  requirements  already 
spoken  of  may  be  arranged  for  by  an  assessment  of 
several  dollars  upon  each  share  of  stock  and  also  upon 
the  junior  bonds.  Sometimes  when  the  future  looks 
hopeful,  the  holders  of  the  senior  bonds  may  be  asked 
to  forego  their  interest  for  a  while  or  to  refund  their 
coupons  into  a  separate  loan  for  which  they  may  re- 
ceive other  securities  under  the  plan. 

In  the  history  of  American  railway  reorganizations, 
it  has  been  a  common  thing  to  find  certain  bonds  or 
shares  given  to  the  old  holders,  to  represent  the  cash 
assessments  which  they  were  asked  to  pay,  or  the 
losses  in  principal  or  interest  to  which  they  were 
asked  to  submit.  Such  a  course  is  justified  by  business 
conditions  in  the  United  States.  In  America  values 
are  largely  determined  by  reference  to  the  future. 
Quotations  of  the  corporation  stocks  or  bonds  upon 
the  exchanges  are  governed  by  two  considerations — the 
present  earnings  and  the  expectation  for  the  future. 
Such  a  method  of  estimating  values  is  to  be  expected 
in  a  large  country  not  yet  fully  developed,  whose  agri- 
cultural and  mineral  possibilities  are  great,  and  which 
on  the  average  is  increasing  in  wealth  and  in  the 
volume  of  business  3^ear  by  year.  The  very  pace  by 
which  industry  usually  advances  leaves  the  way  open 
for  temporary  depreciations,  and  these  for  a  time  may 
curtail  business  to  such  an  extent  as  to  leave  a  railway 


Reorganizations  and  Receiverships      155 

or  other  corporation  unable  to  meet  its  obligations.  If, 
under  these  circumstances  reorganization  becomes 
necessary,  it  is  not  forgotten  that  the  future  may  have 
in  store  for  the  company  greater  earnings  than  are  now 
annually  being  obtained.  Hence  it  is  in  accordance 
with  business  facts  that  the  holders  of  bonds  or  shares 
which,  under  the  stress  of  present  necessity,  must  sac- 
rifice something,  should  ask  that  some  evidence  of 
their  former  claims  against  the  company  be  granted 
them.  They  ask  for  this  evidence  so  that  if  the  com- 
pany in  future  years  should  earn  as  much  as  in  times 
of  former  prosperity  or  indeed  anything  at  all  beyond 
the  present  standard,  these  old  postponed  claims  may 
then  become  alive  again  and  be  worth  something  to 
their  holders.  Nearly  all  railway  reorganizations  re- 
cognize the  justice  of  this  position,  and  the  plans  are 
arranged  accordingly. 

Another  reason  why  the  method  of  giving  some  evi- 
dences of  indebtedness  in  exchange  for  assessments  or 
bond  losses  is  popular,  lies  in  the  fact  that  investment 
sentiment  seems  better  satisfied  where  paper  of  some 
kind  is  given  to  bondholders  in  return  for  their  sacri- 
fices, than  where  such  sacrifices  are  demanded  without 
it.  This  is  true  even  in  cases  where  the  intrinsic  values 
of  the  two  pieces  of  paper  are  no  larger  than  that  of 
one  alone  would  be.  But  even  where  intrinsically  the 
same,  it  is  a  common  experience  that  the  quotations  for 
the  two  are  larger  than  would  be  that  for  one  alone. 
The  great  majority  of  mankind  are  optimists  and  deal 
with  corporations'  shares  and  securities  optimistically. 
The  natural  hopes  of  investors,  therefore,  serve  to  give 
to  an  income  bond  or  a  share  of  stock  dependent  upon 
future  earnings,  a  quotable  value  which  through  senti- 
ment may  be  considerably  higher  than  that  justified  by 
the  present  position  of  the  company. 


156  Corporation  Finance 

For  these  reasons  it  may  be  possible  in  an  easily  ar- 
ranged plan  of  reorganization  to  give  to  the  holder  of  a 
discredited  bond  a  new  bond  for  a  part  of  his  claims, 
and  in  addition  an  income  bond  or  shares  of  preferred 
stock,  in  such  proportion  that  by  selling  both  new  issues 
the  old  bondholder  may  be  able  to  get  back  his  entire 
investment  and  really  lose  nothing.  Such  a  proced- 
ure, however,  is  oftentimes  possible  only  when  the 
capitalization  of  the  new  company  is  largely  increased. 
If  regard  is  had  to  the  present  time  only  and  to  the 
demands  of  the  present  holders  of  the  bonds  of  the 
defaulting  company,  such  a  reorganization  will  be  con- 
sidered a  success  ;  and  it  is  not  to  be  denied  that  the 
wish  to  satisfy  present  demands  is  legitimate  so  far  as 
it  may  be  proper.  But  if  we  regard  the  day  of  reckon- 
ing, such  a  reorganization  may  not  be  defensible.  The 
new  capitalization  may  indeed  be  made  to  mature  long 
years  hence,  but  when  that  maturity  arrives  and  the 
increased  principal  must  be  met,  the  wrongfulness  of  a 
plan  which  increases  the  capitalization,  even  though 
without  an  increase  of  obligatory  charges  at  the  mo- 
ment, becomes  apparent.  And  if,  meanwhile  other 
disasters  should  overtake  the  corporation,  the  old  in- 
judicious arrangement  of  increased  capitalization  will 
make  it  all  the  more  difficult  to  secure  to  the  company 
such  new  money  or  such  concessions  as  it  may  need. 

When  the  holders  of  discredited  bonds  are  asked  to 
surrender  a  part  of  their  principal  and  to  accept  a 
smaller  rate  of  interest,  an  income  bond  to  represent 
the  losses  may  be  offered  to  them.  To  satisfy  the  con- 
ditions of  the  problem,  this  bond  must  be  of  such  a 
character  as  to  be  quoted  in  the  Street  at  such  a  figure 
as  will  reimburse  the  old  holders  for  their  sacrifices  ; 
at  the  same  time,  of  course,  the  object  of  the  reorgani- 


Reorganizations  and  Receiverships.      157 

zation  must  be  kept  in  view — that  is,  to  reduce  the  fixed 
charges.  To  satisfy  both  these  conditions,  the  income 
bond  must  be  made  contingent  upon  earnings  on  the 
one  hand,  and  on  the  other  must  have  also  such  obliga- 
tory features  as  will  commend  it  to  investors.  Al- 
though these  two  features  are  contradictory,  such  a 
bond  has,  in  a  number  of  cases,  been  arranged  for  in 
American  reorganizations.  Experience  has  shown 
what,  indeed,  might  have  been  expected,  that  such  a 
form  of  corporation  capital  works  out  no  better  in  prac^ 
tice  than  in  theory.  On  the  one  side,  the  holders  of 
such  income  or  preference  bonds  are  continually  claim^ 
ing  that  certain  profits  earned  by  the  railway  company 
should  be  paid  over  to  them.  On  the  other  hand,  the 
principal  being  an  obligation,  these  income  or  preference 
bonds  often  stand  in  the  way  of  proper  management  of 
the  finances  of  the  company.  As  every  growing  system 
has  increasing  needs,  the  managers  find  easy  opportuni- 
ties where  the  expenditure  of  a  few  thousands  of  dollars 
would  bring  a  large  return  in  the  way  of  increased 
traflSc  or  profit ;  yet  they  are  debarred  from  borrowing 
money  because  the  income  mortgages  deny  them  that 
privilege.  The  result  of  this  curious  position  is  that 
the  company  does  not  progress  as  it  ought,  the  acuteness 
of  the  managers  being  meanwhile  exercised  to  devise 
means  whereby  the  too  stringent  terms  of  the  in- 
come mortgage  may  be  made  practically  of  no  effect. 
For  illustration,  a  company  may  need  larger  terminals, 
and  these  terminals  may  be  the  means  of  increasing  the 
profits  which  should  go  toward  paying  something  upon 
the  income  bonds.  Being,  however,  unable  in  its  own 
name  to  borrow  the  money  to  pay  for  these  terminals 
(because  the  new  mortgage  cannot  be  put  ahead  of  the 
income  bonds),  the  company  may  arrange  to  have  them 


158  Corporation  Finance 

held  in  another  name,  meanwhile  entering  into  a  con- 
tract with  the  terminal  company  to  pay  over  to  the 
latter  certain  sums  for  the  use  of  the  supposed  ter- 
minals. Such  a  terminal  charge  per  passenger  and 
per  ton  is  agreed  upon  as  will  be  enough  to  meet  the 
interest  on  the  new  terminal  bonds  ;  such  terminal 
charges  being  meanwhile  added  to  the  working  ex- 
penses of  the  system.  In  this  way  practically  the 
interest  on  the  terminal  bonds  is  paid  for  by  the  parent 
company,  although  the  terms  of  the  income  or  preferred 
mortgage  would  forbid  such  a  thing  if  attempted 
directly.  All  these  considerations  being  taken  into 
account,  the  quotations  for  these  income  bonds  often 
rule  so  low  upon  the  stock  exchanges  as  to  make  a 
large  issue  necessary  if  the  original  losses  of  the  bond- 
holders under  reorganization  are  to  be  thus  made  up. 
As  a  consequence,  the  capitalization  of  the  new  com- 
pany is  much  larger  than  that  of  the  old. 

Preferred  stocks  given  in  exchange  for  the  sacrifices 
of  the  old  bondholders  are  much  better  than  income 
bonds  from  the  point  of  view  of  good  corporation  finan- 
ciering. Preferred  shares  may  thus  properly  represent 
deferred  claims.  There  is  no  peremptory  obligation 
resting  upon  the  company  to  pay  an  annual  dividend 
upon  these  shares,  particularly  if  they  are  made  non- 
cumulative.  To  make  dividends  on  preferred  shares 
cumulative  is  not  good  policy  except  in  extreme  cases, 
because  it  lays  the  shares  open  in  modified  degree  to 
the  reasoning  which  has  just  been  applied  to  the 
income  bonds.  Preferred  shares,  too,  have  voting 
power,  and  their  holders,  even  though  small  in  num- 
ber, are  thus  put  in  the  way  of  defending  their  own 
interests  in  the  Board  of  Directors  or  before  it.  More- 
over, while  an  excessive  capitalization  represented  by 


Reorganizations  and  Receiverships.      1 59 

shares  is  an  evil  and  gives  rise  to  some  objectionable  con- 
ditions in  our  corporation  finance,  yet  it  is  by  no  means 
so  dangerous  as  excessive  capital  represented  by  bonds. 
Altogether,  therefore,  preferred  shares  represent  de- 
ferred claims  under  reorganization  much  better  than 
can  income  or  preference  bonds,  and  in  all  cases  of 
reorganization  should  be  issued  for  such  purposes 
where  the  laws  of  the  state  will  allow  of  such  issue. 
The  issue  of  preferred  shares  in  exchange  for  assess- 
ments paid  by  the  common-stock  holders  is  often  made 
expedient  by  the  sentimental  wish  of  the  assessed 
shareholder  to  have  some  special  piece  of  paper  to 
represent  his  payments. 

Legally  the  owner  of  a  single  bond  is  entitled  to  all 
the  rights  and  advantages  which  the  terms  of  the  mort- 
gage may  give.  It  is  becoming  more  common,  however, 
to  limit  the  rights  of  a  small  minority  by  modifying 
somewhat  the  extreme  language  of  the  mortgage.  Rail- 
way mortgages  now  usually  provide  that  the  tniistees 
shall  take  legal  proceedings,  shall  declare  the  principal 
due  and  shall  proceed  to  foreclose,  only  when  a  certain 
percentage  of  the  bondholders  request  it  so  to  act.  Cus- 
tom yet  gives  to  one  half  of  the  bonds  outstanding,  or 
sometimes  to  a  smaller  percentage,  the  right  to  demand 
the  satisfaction  of  their  mortgage  through  the  trustee. 
But  the  legal  right  of  foreclosure  is  one  thing  and  the 
commercial  expediency  is  often  quite  another.  A  sys- 
tem with  a  number  of  different  classes  of  bonds  upon  it 
being  in  diiSiculties,  the  holders  of  some  of  the  junior 
issues  may  be  unwilling  to  agree  to  any  plan  of  reor- 
ganization whatever,  or  may  find  fault  with  the  pro- 
portion of  new  securities  to  be  given  them  under  the 
advertised  plan.  In  either  case  one  half  or  more  of  the 
bondholders  have  the  power  to  compel  the  trustees  to 


i6o  Corporation  Finance 

begin  foreclosure  proceedings.  If  these  proceedings 
are  carried  through,  these  same  bondholders  must  be 
prepared  to  bid  in  the  property  in  order  to  secure  their 
debt.  This,  in  turn,  involves  ' '  financing ' '  the  new 
company.  They  must  often  be  prepared  to  furnish 
money  enough  at  the  sale  to  pay  all  the  floating  and 
current  indebtedness,  and  if  they  would  make  a  success 
of  their  new  company,  they  must  also  be  ready  to 
furnish  the  capital  which  under  our  assumed  con- 
ditions the  system  needs  in  order  to  be  put  in  good 
condition  and  ready  for  economical  working.  These 
two  requirements  may  call  for  so  much  money  that  the 
bondholders  may  well  hesitate  before  they  enter  upon 
such  an  undertaking.  Holders  of  corporation  securi- 
ties are  scattered  throughout  the  country,  and  perhaps 
many  of  the  bonds  are  held  in  Europe.  A  scattered 
majority  stands  rather  helpless  before  such  a  problem  ; 
the  trustee  will  not  act  unless  expenses  are  guaranteed 
to  it,  while  no  banking  house  will  undertake  the  forma- 
tion of  a  new  company  unless  it  sees  clearly  that  the 
conditions  favor  success,  and  unless,  too,  it  has  the 
support  of  a  majority  of  the  mortgage  issues.  It  is 
customary  now  for  committees  to  be  formed  to  protect 
the  interests  of  the  various  securities  involved  in  the 
insolvency.  If  such  committee  succeed  in  getting  the 
greater  part  of  the  securities  deposited  with  it,  it  be- 
comes a  factor  in  the  reorganization  ;  yet  even  when 
this  is  the  case,  such  committee  may  not  be  willing  to 
furnish  the  large  sums  necessary  to  finance  the  new 
company  in  a  manner  favorable  to  the  particular  bonds 
held  by  them. 

It  will  thus  be  seen  that  it  is  better  for  the  bond- 
holders of  a  bankrupt  railway  system  to  accept  a  plan 
of  reorganization,  if  found  equitable,  rather  than  to 


Reorganizations  and  Receiverships       1 6 1 

attempt  to  buy  in  the  property  for  themselves.  If  the 
proposed  plan  of  rehabilitation  is  believed  by  a  majority 
of  all  bondholders  to  be  unfair,  it  will  usually  fall  to 
the  ground  through  lack  of  support ;  that  is,  a  plan,  to 
be  carried  out  successfully,  must  have  the  active  as- 
sistance of  a  majority  of  the  bondholders  given  to  it 
through  a  deposit  of  bonds  of  those  holders  who  assent 
to  the  plan.  No  matter  how  strong  the  language  of 
the  mortgage,  the  bonds  issued  under  it  are  worth  only 
what  the  commercial  conditions  of  the  company  allow  ; 
hence  it  is  better  for  the  holders  of  defaulted  bonds  to 
accept  a  plan  when  found  upon  examination  to  be 
equitable,  than  to  insist  upon  their  legal  rights  ;  for 
their  bonds  are  worth  only  what  their  proportion  of  the 
total  value  of  the  company's  property  comes  to  ;  they 
could  not  get  any  more  than  that  proportion  even 
though  they  insisted  upon  the  full  terms  of  the  mort- 
gage. Corporation  reorganizations  resolve  themselves  U 
into  commercial  problems  rather  than  legal.  — j 

As  business  conditions  change  rapidly  in  a  develop- 
ing country,  it  frequently  happens  that  a  company 
when  insolvent  and  about  to  be  reorganized  wishes  to 
get  rid  of  certain  branches,  guaranties,  leases,  or  other 
contracts  which  in  the  course  of  time  may  have  proven 
themselves  very  unprofitable.  So  long  as  the  corpora- 
tion is  solvent,  the  question  of  the  justice  of  living  up 
to  its  contracts  does  not  arise.  When,  however,  it  con- 
fesses that  it  is  unable  to  pay  its  debts,  then  its  financial 
rehabilitation  becomes  a  question  of  commercial  value, 
and  in  this  light  it  is  deemed  proper  for  a  reorganization 
committee  to  plan  for  a  cutting  ofi"  of  those  branches, 
leases,  or  other  contracts  which  are  recognized  as  bur- 
densome upon  the  company.  Sometimes  a  company  is 
rehabilitated  without  a  sale  of  its  property  at  foreclos- 


1 62  Corporation  Finance 

ure.  In  such  happy  cases  it  has  been  found  possible  to 
make  such  an  arrangement  among  all  the  bond-  and 
stockholders  as  enables  the  old  company  to  rearrange 
its  mortgages  and  shares  and  go  on  with  its  business 
under  the  existing  charter.  In  cases,  however,  where 
unprofitable  branch  lines  have  had  to  be  supported  or 
onerous  contracts  carried  out,  the  determination  to 
relieve  the  company  from  these  burdens  proves  a 
stumbling-block  to  the  easy  form  of  rehabilitation  just 
referred  to  ;  for  whenever  a  company  is  rehabilitated 
by  a  change  in  its  financial  arrangements  and  proceeds 
with  its  business  under  its  old  charter,  all  the  contracts, 
guaranties,  and  leases  which  it  may  once  have  entered 
into  are  kept  alive  and  become  claims  against  the  com- 
pany. The  only  method  of  getting  rid  of  such  burden- 
some guaranties  or  leases  is  through  the  foreclosure  of 
some  one  of  the  mortgages  and  a  sale  of  the  property 
and  franchises  to  another  company.  If  there  is  a  char- 
ter in  existence  whose  privileges  are  such  as  to  meet 
the  conditions  of  the  insolvent  company,  then  the  prop- 
erty may  be  sold  and  conveyed  to  a  company  organized 
under  it.  If  this  is  not  possible,  then  a  new  charter 
must  be  obtained  in  the  state  or  states  concerned. 

It  is  at  this  point  that  new  difficulties  arise.  In 
many  cases  the  charters  under  which  the  insolvent 
systems  are  now  operating  were  granted  many  years 
ago  and  contain  privileges  which  could  not  now  be 
obtained  from  any  legislature  or  from  congress.  It 
may  be  that  the  state  which  originally  gave  the  fran- 
chise has,  since  granting  that  charter,  enacted  new 
laws  which  forbid  perhaps  the  very  things  that  the  old 
charter  permits.  Under  these  circumstances  the  fore- 
closure of  one  of  the  mortgages  on  the  system  and  the 
sale  of  the  property  to  a  company  formed  under  a  ne-^ 


Reorganizations  and  Receiverships       163 

charter  might  involve  the  surrender  of  so  much  of  the 
old  commercial  rights  as  would  render  the  success  of 
the  enterprise  doubtful.  Here,  again,  it  may  be  expedi- 
ent for  the  holders  of  a  senior  or  a  junior  mortgage 
to  make  some  concessions  which  will  allow  of  a  restora- 
tion of  the  plant  into  the  hands  of  the  original  com- 
pany, rather  than  to  insist  upon  the  carrying  out  of 
the  provisions  of  the  mortgage,  which,  though  legally 
clear,  are  impossible  of  fulfilment  except  at  the  ex- 
pense of  the  holders  of  the  bonds  themselves.  When 
systems  having  old  and  valuable  state  or  federal  char- 
ters have  also  burdensome  leases  or  contracts,  the 
adjustment  becomes  one  of  great  difficulty.  If  the 
present  charter  be  retained,  the  onerous  contract  is  still 
in  force  even  though  temporarily  disowned  by  the 
receivers  ;  if  it  is  sought  to  throw  off  these  contracts  by 
a  sale  to  a  company  newly  organized  under  present 
laws,  an  equally  large  or  even  larger  loss  may  be 
entailed.  If  neither  party  will  yield  something  under 
these  conditions,  the  property  may  stay  in  the  hands  of 
receivers  much  longer  than  would  be  otherwise  neces- 
sary, and  longer  too  than  the  courts  prefer  to  keep  the 
control  in  their  possession.  If  at  last  neither  will  yield, 
it  becomes  a  choice  of  evils.  It  may  be  that  during  the 
period  of  embarrassment  the  general  business  of  the 
company  has  suffered  to  such  an  extent  that  the  senior 
bonds  are  affected.  It  then  becomes  a  question  whether 
these  senior  bonds  will  foreclose  their  mortgage  and  let 
the  property  go  for  what  it  will  bring  ;  in  such  cases 
the  breaking  up  of  large  and  important  systems  is  a 
thing  to  be  lamented  in  the  interest  of  the  public  no 
less  than  that  of  the  creditors  themselves. 

Before  insolvent  companies  undergo  reorganization 
there  is  usually  a  period  of  receivership.     The  practice 


J 


164  Corporation  Finance 

of  operating  insolvent  railways  through  court  officers 
appointed  for  the  purpose  is  not  yet  definitely  settled 
either  as  to  the  methods  of  working  or  as  to  the  legal 
doctrines  involved,  the  whole  matter  being  yet  in  a 
state  of  evolution.  It  is  the  boast  of  our  law  that  it 
changes  to  meet  the  changing  demands  of  commerce  as 
business  becomes  more  complex  and  the  rules  govern- 
ing it  necessarily  more  involved  ;  so  as  regards  railway 
receiverships  our  present  situation  is  the  result  of  a 
compromise  between  the  terms  of  railway  mortgages 
and  the  commercial  conditions  under  which  railway 
operations  are  carried  on. 

The  original  idea  of  appointing  a  receiver  to  take 
charge  of  the  property  of  a  firm  or  individual  was  that 
the  business  might  be  wound  up  with  as  little  delay  as 
possible  and  the  assets  sold  and  distributed  to  the  cred- 
itors in  some  equitable  proportion.  As  corporations 
became  more  common,  taking  the  place  of  firms  and 
individuals,  the  same  idea  was  applied  to  them  when 
insolvent.  They  were  placed  in  the  hands  of  receivers 
in  order  that  their  affairs  might  be  closed  up  with  the 
least  possible  delay  by  dividing  the  assets  among  the 
creditors  in  the  proportion  to  which  it  was  shown  they 
were  entitled.  It  was  inevitable  that  the  question  of 
the  proper  method  of  treating  insolvency  among  rail- 
way companies  should  arise.  From  small  beginnings 
the  number  of  miles  of  railway  in  the  United  States 
increased  rapidly  until  now,  judged  by  the  magnitude 
of  the  property  invested  and  the  amount  of  business^ 
done,  the  railways  form  perhaps  our  largest  industryJ 
certainly  one  of  the  most  complex.  Through  on^ 
cause  or  another  it  was  inevitable  that  bankruptcj 
should  increase  among  these  rail  carriers  as  their  mile 
age  increased  ;  and  in  such  cases  also  it  was  natural 


Reorganizations  and  Receiverships       165 

as  in  the  cases  of  firms  or  small  corporations,  that 
receivers  should  be  appointed  pending  a  settlement  of 
the  insolvent  debtor's  affairs.  But  here  a  new  quest- 
ion arose.  A  trading  firm  or  corporation  unable  to 
pay  its  debts  could  be  wound  up  and  its  assets  dis- 
tributed to  its  creditors  without  loss  to  the  community. 
Other  traders  could  take  their  places  and  business 
would  go  on  as  before  ;  but  it  was  otherwise  with  the 
railways.  It  was  quickly  seen  that  great  states  and 
sections  of  states  depended  upon  the  continued  opera- 
tion of  these  railways  for  the  transaction  of  their  every- 
day business,  for  supplies  of  clothing  and  manufactured 
goods,  and  even  for  meat  and  bread.  Whatever  the 
outcome,  the  trains  must  be  kept  running.  Since,  in 
the  course  of  time,  local  railways  have  grown  into  sys- 
tems, it  was  found  that  the  interests  involved  in  these 
systems  were  so  enormous  that  their  combined  assets 
could  not  be  easily  sold  as  one  parcel  to  any  one  person 
or  company,  or  sold  separately  without  breaking  up 
the  systems.  Hence,  until  the  serious  questions  of 
reorganization  or  sale  were  settled,  the  receivers  of 
these  systems  must  continue  to  run  the  trains  in  the 
interest  of  the  public.  As  these  necessary  adjustments 
were  often  found  very  complicated,  requiring  a  long 
time  for  negotiations  and  final  agreement,  the  receivers 
appointed  by  the  courts  were  placed  for  the  time  being 
in  the  position  of  railway  managers.  They  were  con- 
fronted with  technical  problems  of  much  practical  im- 
portance. They  were  required  to  become  familiar  with 
disputed  questions  concerning  reasonable  rates  and 
their  ramifications.  The  conflicting  claims  of  cities 
and  towns  as  to  charges  which  should  be  relatively  fair 
to  each  were  pressed  upon  their  attention.  In  short, 
it  was  required  that  receivers  should  be  able  to  form- 


\ 


1 66  Corporation  Finance 

ulate  for  the  operation  of  the  properties  in  their  charge 
a  policy  which  should  be  equitable  to  the  capitalists 
whose  money  was  invested  in  the  road,  to  all  the  sec- 
tions served  by  the  railway,  and  to  the  general  travel- 
ling and  shipping  public.  Needless  to  say,  the  success 
of  such  a  task  required  men  of  administrative  ability, 
with  the  further  result  that  the  courts  through  their 
appointed  officers  were  obliged  to  decide  upon  the 
details  of  administration. 

It  was  the  practice  at  first  for  receivers  to  be  asked 
for  solely  by  certain  creditors  of  the  company  in 
order  that  their  property  might  be  held  together  and 
protected  against  the  seizure  of  certain  parts  of  the 
system  by  other  creditors  which  might  destroy  the 
value  of  the  property  as  a  whole.  Usually  the  corpor- 
ation appeared  before  the  court  in  opposition  to  the 
motion,  so  that,  if  receivers  were  appointed  at  all,  the 
court  acted  upon  information  brought  to  its  knowledge 
after  a  severe  legal  struggle.  The  idea  that  the  corpor- 
ation itself  could  ask  for  an  appointment  of  a  receiver 
for  its  own  property  originated  with  the  late  Jay  Gould, 
whose  contention  in  the  Wabash  cases  in  this  respect 
was  afterwards  affirmed  by  the  Supreme  Court  of  the 
United  States,  which  held  that  a  company  could  itself 
ask  for  the  protection  of  the  court  if  such  was  for  the 
best  interest  of  all  concerned.  Under  this  doctrine  few 
of  our  large  railway  systems  are  now  placed  in  any  but 
*^  friendly''  hands.  In  such  cases  the  matter  is  all 
planned  out  beforehand  and  the  men  chosen.  Any 
creditor  of  the  company,  friendly  to  the  administration, 
may  allege  that  the  corporation  owes  him  money  that 
it  cannot  pay,  and  as  every  going  concern  has  plenty 
of  creditors  in  the  ordinary  course  of  business,  such  a 
convenient  creditor  is  usually  not  hard  to  find.    To  this 


Reorganizations  and  Receiverships       167 

complaint,  usually  prepared  in  secret,  some  one  of  tlie 
company's  officers  arranges  a  reply  confessing  the  truth 
of  the  charge.  All  parties  concerned,  each  with  the 
respective  documents,  and  without  notice  to  the  other 
creditors  or  to  the  public,  apply  to  the  judge,  perhaps 
at  night,  who  forthwith  grants  the  application  and  ap- 
points the  receivers  already  arranged  for.  That  this 
procedure  opens  the  door  to  the  possibility  of  great 
abuse  of  corporate  interests  needs  no  argument.  That 
on  the  whole  the  plan  has  worked  fairly  well  is  ow- 
ing to  the  high  character  of  our  judiciary  and  also 
of  the  officers  in  charge  of  our  great  corporations.  Yet 
it  is  not  reassuring  to  holders  of  stocks,  bonds,  or  float- 
ing debt  to  know  that  a  conspiracy  between  any  small 
creditor  and  any  one  of  the  principal  officers  of  a  cor- 
poration may  throw  the  control  of  the  whole  property 
of  the  company  into  the  hands  of  the  court.  Unques- 
tionably, the  appointment  of  former  officers  of  the  com- 
pany as  receivers  leads  to  the  charge  at  times  that  those 
who  had  wrecked  the  company  are  still  left  in  power. 
Moreover,  the  door  is  open  to  abuses,  such  as  the  diffi- 
culty easily  thrown  in  the  way  of  a  thorough  investiga- 
tion into  the  company's  condition,  which  it  may  be  the 
wish  of  the  old  managers  to  thwart,  but  which  may  be 
necessary  before  an  equitable  plan  of  reorganization 
can  be  evolved.  Yet  the  affairs  of  our  large  corpora- 
tions have  become  so  complicated  that  only  those  long 
familiar  with  them  are  capable  of  administering  them 
without  losses  both  to  owners  of  the  road  and  to  ship- 
pers. This  business  fact  has  so  far  controlled  the 
action  of  the  courts  in  the  appointing  of  old  officers  of 
the  insolvent  corporation  as  receivers,  though  usually 
other  men  not  previously  connected  with  the  company, 
but  representing  important  interests  as  well  as  the  sec- 


1 68  Corporation  Finance 

tions  through  which  the  road  runs,  are  chosen  to  serve 
with  them.  I^aws  have  been  introduced  in  various 
states  to  check  the  abuses  to  which  the  methods  of 
receiverships  have  given  rise,  but  while  these  statutes 
have  done  good  as  to  certain  matters  of  detail,  the  com- 
mercial facts  of  which  we  have  spoken  have  been  strong 
enough  thus  far  to  prevent  any  material  modification 
of  the  policy. 

The  immediate  cause  of  a  railway  receivership  is 
usually  the  floating  debt.  Strictly  speaking,  the  ex- 
pression ' '  floating  debt ' '  means  the  money  borrowed 
by  a  company  on  collateral  and  made  payable  on 
demand  or  within  a  short  time.  The  term,  however, 
is  sometimes  used  to  cover  other  debts  of  the  corpora- 
tion, such  as  for  supplies  which  have  been  bought  but 
not  paid  for.  A  railway  which  is  fairly  prosperous  can 
arrange  to  pay  its  bond  interest  in  a  period  of  depres- 
sion without  showing  signs  of  distress.  Every  large 
business  concern,  such  as  a  manufactory,  must  arrange 
for  a  depreciation  of  plant  and  machinery  before  setting 
aside  earnings  applicable  to  interest  or  dividends.  The 
reason  for  this  is  that,  were  a  contrary  course  to  be  pur- 
sued, the  stock-  or  bondholders  would  very  shortly  find 
themselves  in  possession  of  a  worthless  property.  In 
factories  the  expected  losses  from  depreciation  are  usu- 
ally arranged  for  by  setting  aside  a  certain  sum  of 
money  from  the  earnings  yearly,  but  the  practice  of 
railways  is  different.  It  is  the  custom  with  them  to 
renew  or  replace  roadbed,  track,  and  equipment  from 
year  to  year  as  fast  as  these  deteroriate  or  become  worn 
out,  charging  the  cost  directly  to  working  expenses. 
By  these  means  the  whole  plant  is  kept  up  to  its  stand- 
ard at  the  expense  of  the  earnings,  the  effect  being  the 
same  as  though  specific  sums  had  been  set  aside  from 


Reorganizations  and  Receiverships       169 

income  each  year.  This  method  of  arranging  for  de- 
preciation allows  the  railways  to  vary  the  amount  of 
replacement  from  year  to  year  according  as  the  seasons 
are  prosperous  or  the  reverse.  In  a  good  year  more 
may  be  spent  upon  the  roadbed  and  the  track  and  for 
the  purchase  of  new  equipment  to  replace  the  old  at 
the  cost  of  working  expenses,  than  perhaps  was  pro- 
portionately required.  Then,  in  poor  years,  not  so 
much  of  this  sort  of  work  may  be  done,  allowing  a 
larger  proportion  of  gross  income  to  be  payable  to  bond- 
and  stockholders.  This  saving  in  the  working  expenses 
by  a  stoppage  of  repairs  to  the  plant  is  usually  the  first 
resort  of  the  railway  manager  when  pressed  for  im- 
mediate money  to  pay  bond  interest.  Then  there  are 
always  demands  for  new  capital  for  improvements 
necessary  to  be  made  by  every  railway  as  its  traffic 
increases.  Ordinarily  bonds  are  sold  to  meet  these 
capital  charges.  If,  because  of  a  lack  of  confidence  on 
the  part  of  the  investing  public,  or  a  lack  of  credit  as 
regards  this  particular  company,  such  bonds  cannot  be 
sold,  except  perhaps  at  a  great  sacrifice,  then  the 
management  proceed  to  borrow  the  necessary  money 
for  these  capital  improvements  and  perhaps  for  the 
then  due  bond  interest.  Usually  the  company  must 
hypothecate  with  the  bankers  from  whom  the  money  is 
borrowed  bonds  either  of  the  company  itself  or  such  as 
are  held  in  its  treasury  and  controlling  subsidiary  lines 
important  to  the  integrity  of  the  system,  so  that  the 
banker's  loan  may  be  fully  secured.  If  matters  go 
from  bad  to  worse,  if  it  appear  to  the  lender  that  the 
situation  of  the  company  is  becoming  more  and  more 
critical,  so  that  he  is  beginning  to  doubt  the  real  value 
of  the  collaterals  held  by  him,  he  then  calls  for  his 
money,  if  it  is  loaned  on  demand,  or  gives  notice  that 


1 70  Corporation  Finance 

he  will  ask  for  it  wlien  the  same  shortly  matures.  If 
the  company  cannot  arrange  to  borrow  the  amount 
from  some  one  else,  and  if  it  is  confronted  with  the  sale 
of  all  its  securities  at  bankrupt  prices,  the  managers 
may  resolve  to  confess  their  own  insolvency  before  a 
public  confession  is  made  by  the  sale  of  the  securities 
held  by  the  banker.  Perhaps,  just  at  this  moment,  a 
large  amount  of  interest  is  due  to  bondholders.  In 
such  a  case  the  railway  managers  may  choose  to 
default  on  the  bond  interest  and  take  the  money  for 
payment  to  the  floating-debt  holders,  in  order  to  save 
for  the  company  the  collateral  which  the  bankers  may 
hold,  and  which  may  be  essential  to  the  control  of  parts 
of  the  system,  but  which  would  very  likely  go  for  a 
song  if  pressed  for  immediate  sale.  While,  therefore, 
floating  debts  do  not  difier  from  other  obligations  of 
the  company  except  in  form,  they  have  come  to  be 
recognized  in  Wall  Street  as  a  source  of  great  danger 
in  any  period  of  business  depression  or  lack  of  credit. 
If  this  money  borrowed  on  demand  or  on  short  notice 
can  be  funded  into  bonds  having  years  to  run,  the  com- 
pany cannot  suffer  through  a  demand  upon  it  for  the 
principal,  but  it  is  safe  so  long  as  the  interest  is 
promptly  paid.  This  reasoning  has  led  railway  com- 
panies at  times  to  adopt  the  plan  of  selling  long-time 
bonds  in  order  to  pay  off"  the  floating  debt,  even  though 
the  price  received  should  be  far  below  par.  But  such  a 
course  compels  the  company  to  pay  a  very  high  rate  of 
interest  during  the  whole  life  of  the  bonds  and  is  con- 
sidered such  bad  financiering  that  such  sales  are  taken 
in  Wall  Street  as  an  acknowledgment  that  the  company 
is  hard  pressed — ^with  results  to  the  credit  of  the  cor- 
poration almost  as  bad  as  though  the  distress  had  been 
openly   acknowledged.      Under   these   circumstances, 


Reorganizations  and  Receiverships      171 

'*  friendly  ''  receivers  are  often  asked  for  so  that  inter- 
est may  be  withheld  from  the  bondholders  and  used  to 
take  up  the  obligations  of  the  company  immediately 
pressing,  particularly  in  cases  where  a  failure  to  meet 
those  obligations  would  entail  severe  losses  upon  the 
system  for  all  time. 

The  court  appointing  receivers  thus  asked  for  usu- 
ally stipulates  that  debts  incurred  in  the  operation  of  a 
road  for  several  months  shall  be  paid  by  the  receivers. 
At  first  blush  it  would  appear  that  such  an  order  entails 
hardship  upon  the  creditors  of  the  company,  yet  upon 
examination  it  will  be  found  to  be  equitable.  Trans- 
portation is  conducted  as  a  cash  business.  Travellers 
and  shippers  are  required  to  pay  their  money  down 
before  taking  their  journey  or  receiving  their  property. 
Since  a  railway  must  be  run  in  the  interest  of  the  gen- 
eral public,  and  since  this  involves  the  theory  that  its 
working  expenses  must  be  paid,  it  is  clear  that  the 
expenses  of  to-day  are  properly  chargeable  to  the  gross 
receipts  of  to-day  paid  in  cash  by  the  patrons  of  the 
road.  But,  as  we  have  seen,  in  periods  of  distress,  the 
managers  in  order  to  postpone  a  confession  of  bank- 
ruptcy in  the  hopes  that  the  temporary  trouble  may  be 
tided  over,  begin  to  put  off  payments  for  wages  or  for 
coal,  rails,  ties,  and  supplies  of  all  descriptions  which 
they  may  continue  to  buy,  because  necessary  for  the 
continued  operation  of  the  trains.  In  this  way,  at  the ) 
date  of  appointment  of  receivers,  every  bankrupt  road 
has  large  arrears  of  wages  and  accounts  to  be  made  up. 
As  these  current  obligations  are  really  chargeable  to 
the  receipts  of  the  several  months  past,  and  as  these 
receipts  have  been  taken  to  pay  bond  interest  or  for 
other  purposes  in  the  interest  of  the  bondholders,  it  is 
proper  that  the  prior  claims  for  current  expenses  should 


172  Corporation  Finance 

be  made  up  from  the  first  receipts  of  the  road  under  the 
receivership.  If  there  is  any  complaint  to  be  made  on 
the  part  of  the  bondholders,  it  is  that  the  knowledge  of 
these  facts  has  not  been  brought  to  their  attention  ; 
but  usually  in  such  a  matter  the  managers  of  the  road 
act  in  good  faith,  in  the  hopes  that  better  times  may 
enable  them  to  pay  up  the  back  debts  and  save  the 
indirect  losses  to  the  bondholders,  which  a  public  con- 
fession of  the  real  situation  would  at  that  time  have 
caused. 

The  heavy  expenses  confronting  the  receivers  at  the 
time  of  their  appointment  are  met  partly  from  defaulted 
bond  interest  and  perhaps  from  receivers'  certificates. 
At  first  these  certificates,  generally  made  a  first  lien  on 
the  property,  were  authorized  very  sparingly  by  the 
courts  and  only  in  cases  shown  beyond  dispute  to  be 
necessary.  Gradually  such  issues  were  extended,  until 
the  present  practice  is  for  authorization  of  certificates 
for  any  purpose  which  the  court  may  be  led  to  believe 
is  for  the  ultimate  benefit  of  the  road.  In  this  way  an- 
other mortgage  is  put  ahead  of  the  regular  mortgage 
whose  bonds,  held  by  the  public,  have  been  supposed 
and  declared  to  be  a  prior  lien  upon  the  road.  The 
force  of  circumstances  often  thus  impairs  the  rights  of 
existing  mortgages  though  these  be  drawn  in  strong 
legal  language.  The  right  to  issue  receivers'  certifi- 
cates has  been,  and  may  be,  greatly  abused.  In  one 
case  the  expense  of  operating  greatly  exceeded  the  re- 
ceipts. The  property  and  franchises  should  have  been 
sold  at  once  so  that  the  first-mortgage  bondholders 
might  at  least  have  received  the  value  of  the  rails  and 
equipment ;  but  the  court  allowed  the  receivers  to  go 
on  running  the  road  until  the  certificates  issued  to 
make  up  the  losses  amounted  to  more  than  the  value 


Reorganizations  and  Receiverships.      i  ']2^ 

of  the  property,  the  bondholders  not  getting  a  cent. 
Receivers'  certificates  should  be  authorized  only  when 
a  careful  judgment  tempered  by  conservatism  justi- 
fies their  issue.  As  just  said,  the  directors,  at  the  first 
appearance  of  a  decline  in  profits,  economize  in  de- 
preciation expenses,  hoping  for  better  times.  If  the 
decline  continues  and  a  receivership  ensues,  the  pass- 
ing of  the  property  into  the  hands  of  the  court  is 
an  acknowledgment  of  facts  regarding  impairment  of 
income  which  are  true  though  not  before  generally 
known.  Hence  the  issue  of  receivers'  certificates 
commercially  represents  the  impairment  of  income  just 
referred  to,  but  which  at  the  time  was  not  enforced 
against  the  bondholders.  Railway  mortgages  are  not 
sacred  because  of  the  strong  legal  terms  in  which  they 
are  drawn,  but  are  dependent  upon  success  in  the  busi- 
ness of  transportation,  differing  in  this  respect  from 
real-estate  mortgages  which  rely  more  upon  the  pros- 
perity of  the  whole  community.  The  legal  doctrine 
of  certificates  is  in  a  state  of  evolution,  with  a  tendency 
to  approximate  its  working  to  the  business  circum- 
stances. Our  practice  of  railway  receiverships  is  thus 
a  development  of  our  own  circumstances  and  a  sort  of 
compromise  between  the  too  strong  language  of  our 
mortgages  and  the  actual  conditions  of  the  business  of 
transportation. 

A  receiver  may  decline  to  pay  the  rentals  due  to 
leased  lines  or  the  interest  owing  on  guaranteed  bonds 
if  these  lines  are  at  the  time  of  the  receivership  unpro- 
fitable, no  matter  how  necessary  to  the  parent  company 
these  branches  may  once  have  been.  But  the  old  con- 
tracts are  still  legally  in  force  against  the  company,  and 
can  be  thrown  off  only  by  a  sale  of  the  franchise  and 
property  to  a  new  corporation.     Such  a  sale  sometimes 


1 74  Corporation  Finance 

would  involve  a  forfeiture  of  valuable  charter  rights 
besides  a  long  legal  struggle  ;  and  in  such  reorganiza- 
tions committees  usually  try  to  formulate  some  plan 
which  shall  bring  the  fixed  charges  below  the  mini- 
mum profits  by  allotting  the  necessary  losses  among  all 
classes  of  securities  in  proportion  to  their  respective 
values  to  the  system  as  a  whole — a  process  which  does 
not  regard  the  liens  of  the  mortgages  so  much  as  the 
worth  of  the  lines  they  cover.  But  with  plans  of  reor- 
ganization, the  receiver  properly  should  have  nothing 
to  do. 

The  legal  doctrine  and  the  practice  regarding  receiv- 
erships and  receivership  problems  have,  in  the  United 
States,  been  developed  thus  far  largely  in  the  affairs  of 
railways.  Railways  so  clearly  have  public  duties  to 
perform  that  it  was  inevitable  that  questions  regarding 
their  continued  operation  should  require  settlement. 
This  point  once  settled,  matters  of  detail  about  the 
proper  working  would  naturally  come  up  for  adjust- 
ment in  the  order  of  their  commercial  evolution. 

For  these  reasons  we  find  the  custom  regarding  rail- 
way receiverships  much  in  advance  of  those  concerning 
other  corporations.  But  though  these  latter  lag  be- 
hind, there  are  not  wanting  signs  that  some  of  the 
problems  of  this  character  which  we  are  trying  to  solve 
in  transportation,  are  in  the  future  to  demand  consider- 
ation in  manufacturing.  When  factories  were  numer- 
ous but  small  and  easily  managed  by  an  individual  or 
by  a  firm  composed  of  but  few  persons,  it  was  not  a 
matter  of  great  public  moment  whether  one  or  two 
firms  failed.  The  demand  could  be  easily  supplied  by 
the  manufacturers  still  in  business  and  perhaps  the 
factory  itself,  belonging  to  the  insolvent  partners, 
would  be  re-opened  and  run  by  another  firm.     The 


Reorganizations  and  Receiverships.       1 75 

case  is  altered  already,  if  we  have  in  mind  the  large 
corporations  formed  to  do  certain  manufacturing  on  an 
extensive  scale,  and  the  point  is  likely  to  demand  more 
attention  in  the  future,  when,  in  the  probable  evolution 
of  things,  the  greater  part  of  our  manufactured  output 
may  be  produced  by  a  comparatively  few  companies 
having  large  capital,  extensive  plants,  and  the  best  of 
appliances — for  to  such  a  state  of  production  are  we 
slowly  tending. 

Already  cases  of  the  insolvency  of  large  manufactur- 
ing companies  have  been  before  the  courts.  In  appoint- 
ing receivers,  it  is  now  customary  in  such  instances  to 
allow  these  officers  of  the  courts  to  continue  the  busi- 
ness. Like  railways,  these  large  corporations  cannot 
very  well  stop  working.  Not  only  are  large  bodies  of 
laboring  men  dependent  for  bread  upon  this  continued 
operation,  but  concerns  throughout  the  country  would 
be  embarrassed  if  their  orders,  perhaps  half  executed, 
should  not  be  completed  at  the  appointed  time. 

Under  our  assumptions,  it  might  not  be  possible  for 
the  customers  of  the  corporation  to  obtain  the  required 
articles  from  any  other  source  of  supply,  and  certainly 
not  in  time  to  go  ahead  with  their  own  plans, — plans 
which  if  not  carried  out  might  cause  financial  embar- 
rassment to  them  also  and  to  others.  In  short,  the 
larger  the  company,  the  more  complete  the  producing 
organization,  the  more  important  to  the  community  is 
its  continued  operation.  We  have  heard  complaints 
from  solvent  companies  or  firms  that  the  competition  of 
factories  in  the  hands  of  receivers  was  unfair  to  them, 
exactly  as  in  the  case  of  railways  ;  but  the  growing 
interdependence  of  trade  and  commerce  leaves  no  other 
alternative. 

This  being  so,  the  discussion  just  had  on  the  com- 


1 76  Corporation  Finance 

mercial  facts  underlying  railway  receiverships  has  a 
bearing  upon  the  immediate  and  future  problems  of 
manufacturing  or  trading  corporations.  This  is  all  the 
more  true  because  these  latter  are  now  issuing  mort- 
gages after  the  manner  of  transportation  companies. 
In  the  present  customs  about  railway  receiverships  and 
their  rapid  evolution  under  the  stress  of  actual  condi- 
tions, and  in  the  philosophy  which  seems  to  underlie 
those  customs,  we  may  catch  glimpses  of  the  probable 
experience  awaiting  the  community  if  large  business 
corporations  are  to  do  the  most  of  our  manufacturing, 
and  if  the  managers  of  those  companies  should  repeat 
the  financial  blunders  or  frauds  which  appear  in  our 
past  railway  history,  or  if  commercial  disaster  should 
compel  a  readjustment  of  capital. 


INDEX. 


Accountants,  public,  19  ;  judg- 
ing of  business,  20 

Accounting  with  branch  lines, 
69  ;  losses  of  branch  lines,  72- 
74  ;  charging  off  old  deficits, 
74  ;  difficulty  in  setting  forth 
facts,  80  ;  excuse  for  optimism, 
80  ;  truth  might  destroy  credit 
and  chance  for  recovery,  80  ; 
general  balance  -  sheets,  8  r  ; 
should  show  full  details,  81, 
82  ;  profit  and  loss  account,  82  ; 
treatment  of  depreciation,  83, 
84  ;  charging  to  income  or 
capital,  82-84  ;  betterments  on 
British  railways,  85  ;  better- 
ments on  American  railways, 
85,  86  ;  operating  expenses, 
87  ;  importance  of  knowing 
cost  of  plant,  88  ;  for  small 
companies,  88 

Accounting  for  mercantile  cor- 
porations, 89  ;  cash,  mean- 
ing oi,  91  ;  customers*  bills 
receivauie,  92;  indirect  obliga- 
tions, 93 ;  customers*  accounts, 
94  ;  merchandise,  95  ;  charac- 
ter of  goods  dealt  in,  96 ;  table 
of  liquidation  values,  97  ;  real 
estate,  97  ;  machinery  and  fix- 
tures, 97;  merchandise  in  bond, 
98  ;  proportion  of  profits  to 
sales,  99  ;  estimate  of  liabilities 
and  assets  revalued,  99,  100 ; 
statements  of  condition,  100, 

lOI 


Accounting  of  railways,  102  ;  in- 
come account,  103;  general  bal- 
ance-sheet, 106,  137  ;  capital 
losses  through  lack  of  credit, 
107;  explanation  of  assets,  107; 
explanation  of  liabilities,  108  ; 
bills  payable  for  supplies,  108, 
169  ;  accrued  interest,  108  ; 
audited  vouchers,  108  ;  rebates 
and  cut-rates,  109  ;  profit  and 
loss,  109  ;  details  of  general 
balance-sheet,  107-109  ;  tabu- 
lated changes  in  general  bal- 
ance-sheets, no;  expenditures 
and  resources  in  yearly  state- 
ments, III  ;  losses  of  subsidi- 
ary companies  as  assets,  11 1  ; 
expenditures  for  capital,  how 
gathered,  112,  113  ;  increase  in 
costofroadandequipment,  113- 
115  ;  statement  of  equipment, 
115  :  life  of  rails,  116;  percent- 
age of  operating  expenses  to 
earnings,  117  ;  examples  of 
operating  expenses,  117,  118  ; 
maintenance  of  way,  119,  169  ; 
maintenance  of  equipment, 
119,  169  ;  average  number  of 
passengers  to  train,  120  ;  cost 
of  fuel,  120  ;  cost  of  motive 
power,  120  ;  freight  train  lad- 
ing, 120  ;  freight  cars  and 
freight  car  mileage,  121,  122  ; 
general  expenses,  122  ;  table  of 
quick    assets    and    liabilities, 

123  ;  bonds  in   treasury,   123, 

124  ;   saving  a  railway,   124  ; 
income  account  under  change 


177 


178 


Index 


Accounting  of  railways. — Con, 
of  management,  125  ;  operat- 
ing expenses  under  change  of 
management,  126  ;  average 
cost  of  a  train  mile,  127  ;  re- 
ports may  give  investor  the 
broad  facts,  129  ;  floating 
debts,  168,  169,  171  ;  see  also 
Great  Eastern  Railway 

Alsopp  Brewery,  20 

American  Sugar  Refining  Com- 
pany, 136 

Atchison,  Topeka  and  Santa  Fe, 
13,  66,  70 

Atlantic  and  Pacific,  70,  71 

B 

Blank  Trading  Company,  90 ; 
estimate  of  financial  position, 

Bonds,  should  fetch  par,  5  ;  if 
issued  at  a  discount,  5  ;  good 
effect  of  issue  to  reasonable 
amount,  7  ;  of  manufacturing 
companies,  11  ;  experience 
necessary  to  establish  values, 
12;  risk  paid  for  by  high  in- 
terest, 12  ;  municipal,  14  ;  of 
railways  dependent  on  success 
of  company,  34  ;  of  railway, 
a  lien  really  upon  net  earnings, 
35  ;  debentures,  36  ;  foreclos- 
ure of  mortgage  to  convey  title 
in  reorganization,  36 ;  prior 
lien,  41,  42  ;  first  mortgage, 
42,  150  ;  income  or  preference, 
42-44,  156-158  ;  the  position 
of  holders  of,  43  ;  collateral 
trust,  44,  45  ;  collateral  trust 
notes,  48  ;  "blanket"  or  sys- 
tem, 49  ;  terminal,  52  ;  funded 
debts  of  railways  generally  can- 
not be  paid  off,  58  ;  listing  on 
the  exchanges,  62  ;  of  branch 
lines,  68-72,  151,  163  ;  of  sub- 
sidiary companies,  guaranteed, 
75,  76,  163;  argument  for  re- 
pudiation of  guaranties,  76, 
77  ;    adjustable    branch    line 


guaranties,^  78;  argument 
against  adjustable  guaranties, 
78  ;  guaranteeing,  questions  to 
be  asked  about,  79  ;  prior  lien, 

150  ;  foreclosing  on  specific 
piece  of  road,  151  ;  terminal, 

151  ;  junior  mortgages  some- 
times assessed  under  reorgani- 
zations, 154  ;  given  for  assess- 
ments, 156  ;  under  reorganiza- 
tion, 1 59-161,  172  ;  selling  of, 
to  provide  for  floating  debts, 
170 

Borrowing  money,  necessary  for 
business  man  or  firm,  i  ;  ex- 
ample of  result,  I  ;  beneficial 
to  all  concerned,  2  ;  effect 
upon  prices  and  profits,  2  ; 
methods  of  collecting  capital, 
3  ;  such  funds  not  to  be  put  at 
hazard,  3  ;  should  be  only  to 
minimum  value  of  property, 
4,  5  ;  if  at  too  high  a  cost,  7  ; 
necessity  of  a  sufficiency  of 
capital,  13  ;  by  small  corpora- 
tions from  banks,  14,  23  ;  mini- 
mum value  of  industrial  com* 
pany,  17  ;  by  railways  in  times 
of  stress,  170  ;  see  also  Bonds, 
Capital,  Mortgages 
Boston  and  Albany  Railroad,  135 
Branch  lines,  their  advantages  to 
parent  company,  63,  64  ;  divis- 
ion of  earnings  wirh  parent 
company,  65  ;  allowances  of 
constructive  mileage,  66-68  ; 
commercial  value  of,  68,  69  ; 
how  determined  in  reorganiza- 
tion, 71;  under  reorganization, 
70  ;  their  deficits,  how  carried 
in  accounts,  72-74  ;  under  re- 
organizations, 163  ;  receivers  of 
parent  company  may  decline 
to  pay  rentals  of,  173 


Capitalization,    see    Bonds,    Ac« 
counting,  Corporations 


Index 


179 


Central  Pacific,  78 

Chesapeake  and  Ohio,  9 

Chicago,  Burlington  and  Quincy, 
58,67 

Chicago,  Milwaukee  and  St. 
Paul,  50 

Chicago,  Rock  Island  and  Paci- 
fic, 138,  139 

Chicago  and  Northwestern,  45, 
47,  58 

Chicago  and  Northern  Pacific,  52 

Claflin,  H.  B.,  Co.,  8,  136 

Cleveland,  Cincinnati,  Chicago 
and  St.  Louis,  51 

Companies,  gas,  27  ;  water,  27  ; 

Companies,  street  railway,  their 
traffic  stable,  27  ;  electricity 
changes  old  conditions,  28  ;  in- 
crease of  travel,  28  ;  reduction 
in  cost  of  equipment  and  re- 
pairs, 28  ;  when  freshly  estab- 
lished, 28  ;  charters,  29 

Corporations,  distinction  between 
public  and  private,  24  ;  state 
regulation  of,  24 ;  widest  infor- 
mation required  concerning, 
25  j  publicity,  a  safeguard 
against  restrictions,  25,  26  ; 
taxation  of,  26  ;  owning  shares 
of  other  corporations,  30  ; 
formed  to  own  competing 
plants,  31 ;  trusts,  31  ;  possible 
advantages  of  combination,  31; 
their  finances,  32  ;  mining  and 
other  short-lived  companies, 
58  ;  accounting  of,  80  ;  evolu- 
tion toward,  131  ;  limited  lia- 
bility, the  essence  of ,  131;  three 
parties  in  interest,  132  ;  profits 
granted  to  firms  often  denied 
to,  132-135  ;  grasping  monop- 
olies not  now  concern  us,  134  ; 
usual  test  of  profits  of,  by  pre- 
vailing rate  of  interest,  134  ; 
uselessness  of  attempts  to  limit 
profits,  135  ;  British  gas  eom- 
panies,  charters  of,  136  ;  divi- 
dends of  British  gas  companies, 
how  related  to  prices  of  gas, 


136  ;  registering  an  increase  in 
value  of  plant,  137, 138  ;  water 
in  stocks  or  bonds,  135,  138  ; 
stock  -  watering,    remedy    for, 

139  ;  gain  in  honesty  if  actual 
capital  could  be  stated,  139  ; 
stock-watering  increases  quoted 
values  of  shares,  140  ;  low- 
priced    shares    not    desirable, 

140  ;  amount  of  capital  little 
effect  upon  rates,  141  ;  reduc- 
tion of  dividend  easier  on  non- 
watered  stock,  141  ;  effects  of 
stock- watering  on  service,  141, 
142  ;  paying  high  dividends  on 
elevated  railroad,  142  ;  illegiti- 
mate stock -watering,  143  ;  laws 
of  New  York  about  increasing 
capitalization,  144  ;  laws  of 
Massachusetts  about  increas- 
ing capitalization,  145  ;  absol- 
ute prohibition  of  stock-water- 
ing, 145  ;  may  become  bank- 
rupt, 146  ;  good  credit  not 
affected  easily,  147  ;  may  owe 
large  sums  on  insolvency,  148, 
173;  not  broken  up  because  of 
insolvency,  163,  164;  receivers 
of,  practice  of,  165 ;  * '  friendly  " 
receivers  for,  166, 167  ;  floating 
debts,  168,  169,  171  ;  payment 
of  floating  debts  required  in 
insolvency,  169,  171  ;  old  con- 
tracts in  force  in  insolvency 
until  reorganization,  173;  valu- 
able charters  in  insolvency, 
174  ;  continuing  operation  un- 
der receivers,  175  ,  industrial, 
under  receiverships,  175,  176  ; 
mercantile,  accounting  of,  see 
Accounting ;  railway,  account- 
ing of,  see  Accounting 

Companies,  see  Corporations,  In- 
corporation 

D 

Denver  and  Rio  Grande,  83 
Dividends,     improve     corporate 
credit,    10  ;    sometimes    paid 


i8o 


Index 


Dividends. — Con. 

when  not  earned,  ii  ;  see  also 
Corporations 


Elevated  Railroad  in  New  York, 

133,  142 
Erie  Railroad,  73,  141 
Evansville  and  Richmond,  76 


Great  Eastern  Railway,  102  ;  in- 
come account,  103  ;  Rich  Val- 
ley branch,  104  ;  deficits  of 
branch,  104  ;  general  balance- 
sheets,  106  ;  general  balance- 
sheets  analyzed,  no;  construct- 
ion account,  114  ;  statement 
of  equipment,  115  ;  statements 
of  operating  expenses,  117, 
118  ;  table  of  quick  assets  and 
quick  liabilities,  123  ;  income 
account  under  new  manage- 
ment, 125  ;  operating  expenses 
under  new  management,  126 


Incorporation  of  firms,  16 ;  bank- 
ing houses  in  connection  there- 
with, 17  ;  advantages  of,  for 
family  concern,  22  ;  not  for  un- 
stable businesses,  59;  profits  set 
down  in  prospectus,  136;  origi- 
nal cost  of  plant  not  stated, 
136 

Illinois  Central,  45,  47,  67 


Louisville  and  Nashville,  6,  50, 
73 

M 

Management,  importance  of,  in 
corporate  affairs,  21 ;  of  Ameri- 
can railways,  128 


Mortgages  on  dwelling  houses, 
33  ;  not  dependent  on  business 
success  of  borrower,  33  ;  rail- 
way, wording  about  lien  not  to 
be  construed  too  literally,  35  ; 
railway,  description  of,  39-41 ; 
more  careful  drawing  discussed, 
60,  61 ;  foreclosure  under  re- 
organization, 159,  160;  affected 
by  commercial  conditions,  161 ; 
development  of  receiverships 
under,  173  ;  see  also  Bonds, 
Corporations,  Reorganizations 

N 

New  York  Central  and  Hudson 

River,  36 
Northern  Pacific,  48,  53,  65 

O 

Oregon  Railway  and  Navigation, 

46 
Oregon  Shori  Line,  46,  66,  67 


Pennsylvania  Railroad,  87 
Philadelphia   and   Reading,    10, 

44 
Pittsburgh,  Cincinnati,  Chicago 

and  St.  Louis,  75 
Proctor  &  Gamble  Co.,  136 


Receivers,  to  operate  railway 
pending  plan  of  reorganiza- 
tion, 37  ;  must  pay  certain 
debts,  148,  171  ;  authorized  to 
pay  certain  interest,  152  ;  legal 
practice  of,  not  settled,  164 ; 
original  theory  of  appointment, 
164;  of  railways,  problems  con- 
fronting, 165, 166, 174;  of  trad- 
ing firms,  165, 175;  "friendly," 


Index 


i8i 


i66,  167  ;  certificates  of,  172, 
173;  may  decline  to  pay  under 
old  contracts,  173  ;  practice 
under,  a  compromise,  173  ; 
probabilities  regarding,  as  to 
industrial  companies,  1 74  ;  see 
also  Reorganizations 
Reorganizations,  affecting  branch 
lines,  70-72  ;  large  amounts  of 
money  must  often  be  raised  in, 
148,  149 ;  earning  power  of 
company  must  be  ascertained, 

149  ;  division  of  losses  among 
security-holders,  150  ;  good 
bonds  should  be  undisturbed, 

150  ;  various  mortgages  under, 
150,  151  ;  courts  do  not  favor 
disintegration  of  systems,  152  ; 
losses  of  shareholders,  152  ; 
assessments,  153;  so-called 
"rights"  of  shareholders,  153, 
154  ;  position  of  junior  secur- 
ities, 154  ;  bonds  or  shares 
given  for  assessments,  154  ; 
equity  of  giving  evidence  of 
future  claims  for  assessments 
or  bond  losses,  155,  156  ;  work 
of  committees,  149,  160,  161  ; 
increasing  capitalization  under, 
156;  increased  capitalization 
represented  by  bonds  or  stock, 
159;  not  hindered  by  language 
of  mortgages,  161  ;  as  com- 
mercial problems,  1 61-163 

Richmond  and  West  Point  Com- 
pany, 37,  73 


S 

Shareholders  are  partners  in  the 
enterprise,  7  ;  position  of,  un- 
der reorganization,  152-154 

Sinking  funds,  53-58 

South-em  Railway,  37,  41 

Stock,  common,  when  exchanged 
into  preferred,  10  ;  amount  to 
be  issued  at  incorporation,  18 

Stock,  preferred,  should  have 
preference  upon  assets,  8;  when 
more  advisable  than  bonds,  8  ; 
often  represents  old  debts 
scaled  down,  9  ;  ethical  claims 
when  so  issued,  10  ;  given  for 
assessments,  156  ;  under  reor- 
ganizations, 156,  158;  cumulat- 
ive dividends  under  reorganiz- 
ation, 158 

Stock  watering,  see  Corporations 

St.  Paul  and  Duluth,  9 


Trustees  under  mortgages  usually 
trust  companies,  38  ;  their  re< 
sponsibility,  59 

U 
Union  Pacific,  48,  66,  68,  71 

W 

Wabash  Railroad,  46,  51 
Wisconsin  Central,  53 


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